How to calculate your asset allocation

Sonnie Bailey

16 September 2018

The most important thing to get right when investing in financial assets is asset allocation.

"Asset allocation" refers to how your funds are invested across different classes of financial assets, such as shares and bonds.

If you get this wrong, it doesn't really matter what your underlying investments are. You won't be invested appropriately.

We can get caught up by focusing on different types of financial assets, like cash, cash equivalents, term deposits, shares, and listed property trusts, and the like.

But it doesn't have to be that complicated. The central distinction should relate to the level of assets to invest in:

  • “growth” assets, such as shares and listed property trusts, versus
  • “defensive” assets, including cash, cash equivalents, bonds, and term deposits.

Growth assets versus defensive assets

Growth assets tend to have higher volatility. This means that the returns they generate (such as from dividends and capital gains/losses) can vary significantly from year to year. With growth assets, you have a higher likelihood of losing money in any given year.

Defensive assets, on the other hand, are much more stable in comparison. This doesn’t mean that defensive assets aren’t without risk. The downside with defensive assets is that their returns tend to be much lower than the return of growth assets – especially after factoring in inflation, which eats away at the value of investments.

Over the long-run, growth assets tend to generate better returns than defensive assets. Because of this, there is a legitimate risk of being too heavily invested in defensive assets and ending up in a worse position over the long-run than you would have been by investing in growth assets.

(If you own an investment property, this is a growth asset. If you've borrowed to invest in property, the rest of this article probably isn't for you.)

Resources for calculating your asset allocation

One way of calculating your asset allocation is to use a tool like Sorted's Investor Kickstarter. You answer a few questions and it will give you a description of how a typical investor like you might invest.

Or you can invest in a life tracker managed fund, which changes your asset allocation as your age changes. For example, SuperLife's Age Steps investment options.

These approaches are great for people with very simple investment needs, like someone who is working, has a home, and doesn't expect to use their investments for the very long term.

However, most people have specific cash flow needs and expectations at various points, and most online calculators don't factor this in.

For example, consider someone who is fast approaching retirement, or is shifting from full-time to part-time work. They have a few big holidays planned and some major purchases anticipated. Their cash flow needs are going to be quite variable and their investment approach should anticipate these plans.

I've grown increasingly frustrated with online calculators that suggest an asset allocation without asking about cash flow needs. They're way too simplistic.

Below, I explain a "bucket strategy" approach for calculating a suitable asset investment allocation.

Thinking in terms of "buckets"

When determining an appropriate asset allocation, it can be helpful to think of your investments in terms of three “buckets”.

  1. A bucket relating to your expected cash flow needs for the next three years.
  2. A bucket relating to your expected cash flow needs for the following five years.
  3. A bucket relating to your cash flow needs in eight years' time and beyond.

Thinking in terms of these three buckets can be handy, but it might be suitable for you to think in terms of more or less buckets, or in relation to different buckets/time frames. If you understand the principles, you can apply them to your own situation.

Bucket #1
Your cash flow needs for the next 3 years

For bucket 1, you estimate your cash flow needs for the next 3 years, and put this amount into bucket 1.

If you don't think you'll need to use any of your investment portfolio during this period, and can live off income from other sources, the figure will be $0. If, on the other hand, you need to use your investment portfolio to supplement other income sources (such as wages or NZ Super), or you have large one-off expenses, this is where you'd factor these in. 

With this bucket, invest very conservatively. You want to have certainty that these funds will be available as you need them, and you don’t want this going up or down at all.

For this bucket, I would invest 100% in defensive assets (ie, cash, cash equivalents, and fixed interest products such as bonds).

Bucket #2
Your cash flow needs for the following 5 years

With this bucket, you want to invest fairly conservatively. You don’t want to be exposed to extreme volatility. However, given the moderate time frame, it’s worth investing in some assets that give you the potential for growth above the rate of inflation.

The exact proportion of defensive to growth assets would depend on your risk profile, plus any other specific factors – including, for example, whether you expect to spend a significant lump sum on a particular purchase and the degree of certainty you have about that purchase.

Quite often, my baseline for this bucket is investing approximately 67% in defensive assets and approximately 33% in growth assets. However, I adjust this to reflect a person's risk tolerance as well as other factors such as the degree of certainty they have over their cash flow needs.

Bucket #3
Your expected cash flow needs in 8 years' time and beyond

The amount of funds in bucket 3 equals your investment portfolio, less what is in buckets 1 and 2.

With this bucket, I would invest more aggressively. You don’t need these funds for quite some time, so although there will be volatility over the short-term if you invest more aggressively, it should work in your favour over this extended time frame.

As with bucket 2, the exact proportion of defensive assets to growth assets will vary depending on your circumstances. For many people, I start with a baseline of investing approximately 33% of the funds earmarked for this bucket into defensive assets, and approximately 67% in growth assets. For some people, I would go as high as 100% of funds in growth assets. Conceivably, I would also go significantly lower, for example if someone had absolutely no tolerance for investment volatility and no need to take it on.

An example

Let’s assume that you’ve just celebrated your 65th birthday. You’ve retired from work and you’re receiving $21,000 per year from NZ Super. You’ve accumulated financial assets of $390,000 on top of your mortgage-free home. You expect to spend $35,000 per year throughout your retirement, but have a few one-off expenses planned.

Bucket #1

Your cash flow needs:

$14,000 per year (ie, $35,000 less $21,000 NZ Super) x 3 years = $42,000.

On top of this, you want to travel in the first three years of your retirement, to the tune of $10,000 per year – or $30,000 in total.

You also plan to spend $10,000 upgrading your car in the first year of your retirement.

The total amount you need to earmark for this bucket is $82,000.

Defensive assets to allocate:

$82,000, or 100% of assets in bucket 1

Growth assets to allocate:

$0, or 0% of assets in bucket 1

Bucket #2

Your cash flow needs:

$14,000 per year x 5 = $70,000.

In these five years, you would like to earmark $5,000 per year for travel ($25,000).

The total amount for this bucket is $95,000 – but let’s add $5,000 as a buffer, and to bring the figure to $100,000.

Defensive assets to allocate:

$67,000, or 67% of assets in bucket 2

Growth assets to allocate:

$33,000, or 33% of assets in bucket 2

Bucket #3

Your cash flow needs:

Subtracting $82,000 (bucket 1) and $100,000 (bucket 2) from your investment portfolio of $390,000 comes to $208,000.

Defensive assets to allocate:

$69,333, or 1/3 of assets in bucket 3

Growth assets to allocate:

$138,667, or 2/3 of assets in bucket 3

Total allocation:

$218,333 in defensive assets and
$171,667 in growth assets

Some things to keep in mind

This exercise involves as much art as science

The example above concluded with some precise figures.

But underlying these figures are assumptions about future cash flow needs, as well as some simplifications to avoid these calculations from being needlessly complex. 

The goal isn't to come to "the perfect asset allocation". A perfect allocation doesn't exist.

The goal is to come to an asset allocation that's suitable for your circumstances, nested within the many uncertainties we all face - including in relation to your future cash flow needs and your future investment returns. 

You don't need to separate your investments into buckets

This "bucket" approach for calculating an asset allocation is a good way of conceptualising how much you should invest in growth assets relative to defensive assets.

You don't actually need to invest separately according to the buckets. In fact, I'd recommend against that - as it creates unnecessary complexity.

In practice, implementing the asset allocation above could be as simple as:

  • Investing $40,000 or so into a high-interest transactional bank account, covering cash flow needs for the next 12 months (with a small buffer)
  • Investing $180,000 into a low-fee managed fund that invests exclusively in conservative investments. For example, SuperLife's Income fund. 
  • Investing $170,000 into a low-fee index-based managed fund that invests exclusively in growth investments. For example, SuperLife's 100 fund. 

Or you could achieve a similar asset allocation by investing $300,000 in Simplicity's Balanced fund (which targets an allocation of 56% growth to 44% defensive assets - giving you exposure to $168,000 in growth assets), with the remainder of your $390,000 in term deposits or a fund similar to the SuperLife income fund. This is slightly more complex but might save you fees.

Review your asset allocation every 12 months or so.

Once you calculate your asset allocation, you should be able to forget about it for some time. You shouldn't worry about it, until it's time for a periodic review.

When I talk about a periodic review, I don't mean you should review it every day or week.

At the most, I'd recommend reviewing your asset allocation every year or so. Or if your circumstances, needs, and objectives change radically.

Whatever prompts your review, changes to your allocation should be driven by your circumstances, needs, and objectives. For example, changes in your cash flow expectations, changes in your health, and changes in your values and priorities. Over time, it may be influenced by the investment returns you've generated. But you should be slow to change your expenditure based on short-term investment returns - especially when it comes to increasing your expenditure. 

As with all investment decisions, your asset allocation should be driven by you and not what markets are doing or what you read about in the paper or see on the TV. 

Getting your asset allocation right is important. If you get it right, you're most of the way there when it comes to investing in financial assets. If you get it wrong, it's hard to correct.

I hope this is useful! If you have any questions or feedback, let me know.

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