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This newsletter discusses what asset allocation means in terms of an investment strategy and compares different types of investment methods and techniques. Investing smarter is one of the key principles of the Life Stages Wealth Creation structure (see our May ‘06 newsletter).

Before you invest, it is wise to decide why you are investing and what type of wealth you need to create. The three pools of wealth to consider are:

1. Peace of mind wealth - funds for day-to-day living and short-term emergencies or goals.
2. Lifestyle wealth - medium to long-term goals, including overseas holiday or upgrade the car.
3. Retirement wealth - to fund life after retirement, either to supplement the government aged pension or be independent of it.

Each of these pools usually has a different investment strategy and product selection. Our focus will be on the medium to long-term wealth creation, but remember to consider the peace of mind wealth and the day-to-day needs in your strategy.

Nearly all of us understand that putting all your weekly surplus cash under the bed is better strategy than spending it, but in time the value of that cash decreases (due to inflation and cost of living rises). Having that cash sitting in a cheque account at a local bank is better again, but unless it is earning interest at least as high as the CPI figure, you are still losing future purchasing power. These two methods may satisfy peace of mind, but it is unlikely to fund your lifestyle or retirement needs

Investing smarter is about getting your money to work for you, growing on a daily basis at a return and risk level you are comfortable with and aimed at achieving your goals. There are many ways people invest, some with a plan, most without. More and more, individuals and couples are buying shares or stocks in specific companies, such as Telstra, BHP Billiton, Woolworths or the major banks. The more risky investors buy based on tips from their brother-in-law who heard it from Fred who was down the pub last night. If you regard this type of purchase as play money and it won't hurt if you lose it all and you have fun doing it, by all means, go for it, however it is not the suggested strategy for long-term wealth creation.

The two basic approaches of an investment strategy are; the strategic top-down approach or the bottom-up approach. The top-down approach looks at the macro-environmental factors first, world demand, demographic trends, political influences etc to then select a range of countries to invest in, then industries and finally sectors. The bottom-up approach is about picking individual companies or winners. Within each of these approaches, there is a further methodology of an active trading style in attempting to time the market by buying low and selling high, as compared to a passive style of a long-term buy and hold approach. The approach and style will be determined by the individual investors themselves, what knowledge they have, what time they can commit and what costs are they comfortable paying.

The real issue is, is there any difference in the performance or returns between the approaches?

The research is clear. Between 70 to 90% of a portfolio's (being the selection of investments held) performance is due to asset allocation, while the remaining 30 to 10% is determined by asset selection within the asset classes, i.e. Individual stock/share selection.

Asset Allocation refers to the type of asset classes, where the five main forms of Assets all bear different returns based on their risk.

1. Cash at the Bank is seen as a very safe environment where it is very unlikely that you will lose your investment or cash, consequently as the risk is low, so are the returns, perhaps on a cash management account, 1 to 2% above CPI.
2. Fixed Interest investments, being government bonds and company debentures, mostly secured earn 2 to 3% above CPI, again a relatively risk free investment.
3. The Property market has been very strong in Australia over the last decade, however most expect this to be flat for the next few years. It can return a negative amount, on average every 14 years or so. People investing in the Sydney market are feeling this now, yet the WA and Qld markets are growing strongly.
4. Australian equity or share market is a more volatile market, a negative return every 4.3 years but returning 6 to 8% above CPI.
5. The last form is International Shares, again moving up in terms of risk or the possibility of a negative return but mostly generating higher returns.

The graph on the right shows the 10 year growth (to Sept '04) of an initial $10,000 investment in the first four asset classes. While this slightly unusual in the fact that Property performed so well, it highlights the differences in performance between the asset classes. Bank Bills doubled to $20,000 in the ten years, yet Shares went to $35,000 and Listed Property to $45,000.

It is critical that you understand what your risk profile is, that is where you can be comfortable to be able to sleep at night understanding the potential consequences of your investment decisions. The graph on the left shows the same asset classes over the 10 year period and the volatility in return. Shares (All Ords) are highly volatile, Listed Property Trusts are less so and Bonds (fixed interest) are relatively stable.

There is little point taking on a higher risk (or volatility) than is necessary unless you can afford to lose the money. Having an understanding of where you are in achieving your goals, what you need to further generate and how long your investment time frame is, are all key components in the equation to be considered.

This leads us to how we construct a portfolio based on weighting of asset classes. There are a number of suggested models available from various suppliers, investment houses and brokers. One illustrative model is shown below based on risk profile and the suggested asset class mix:

Even after all that, there are still factors to consider.

• Do you invest yourself or use a financial planner or investment house?
• Are you after income return or capital growth or a combination?
• What investment vehicle are you using, as an individual, within a trust or company structure or within a self managed superannuation fund?
• Can you make portfolio selections in your retail or industry superannuation fund?
• Do you favour the active trading style (normally meaning higher costs due to research and trading costs) or a passive approach (lower costs due to a buy and hold approach). The costs will affect your end returns.
• For Property, will you be a direct investor (purchase the property yourself, residential or commercial) or will you be an indirect investor using either listed or unlisted property trusts?
• For Australian shares, are you a blue chip investor after the benefits of liquidity (being able to easily sell on the ASX) and franking dividend tax benefits, or are you a value small cap investor or something else?
• For International shares, which countries are attractive and you believe have long term growth and return potential?

The first component of an optimum portfolio decision is the investment decision , however you still need to consider the second component, being the finance decision . How much do you borrow (or lend)? A topic for another day.

Please note, we do not provide financial product advice, you need to see a licensed financial advisor for that advice. This newsletter is for educational purposes only for our clients.

If you would like to know more about what you could borrow based on available cash flow and value of your property, give me a call. We will work with your accountant or advisor to structure a solution that suits your needs and circumstances. We take the approach of looking at your long term goals and working to find a solution through finance for you. This appointment is no-cost and is obligation free, call – 9397 7275

Helping People through Finance

Information for the graphs was obtained from - http://www.asx.com.au/investor/lmi/how/property_trusts_graphs.htm