What is your asset allocation?

When it comes to personal finance, asset allocation is really, really, really important. I talk about it a lot, because for most people it should be central to how they think about their investment strategy.

Ways to think about asset allocation

There are many ways to slice and dice the way your investments are made up. I don't think there's a single, exclusive way you should do it. Instead, you should think of how your investments are split in a few different ways.

For most clients I take two main approaches:

• Break down investment assets into different "classes" of assets, such as cash & savings, term deposits, bonds, Australasian shares, international shares, listed property, property, "exotic" assets (which may be subcategorised, eg cryptocurrency like Bitcoin, art, or exotic cars (if they really know what they're doing), etc), and business interests.
• Break down investment assets into two very broad categories: "defensive assets" (such as cash & savings, term deposits, and bonds) and "growth assets" (eg shares and property). I'm not usually a fan of black-and-white, dichotomous thinking, but most investment assets fall pretty easily into one category or the other.

For some clients I go into more detail. For instance:

• I look at their total assets, broken into "personal assets" (eg home(s)) and "investment assets" (all of the asset classes listed above).
• Sometimes I distinguish between specific investments. For example, if a client has a lot of wealth tied up in one or more specific assets – such as an interest in one or more companies, or several rental properties, I might see how these individual investments fit within their broader asset allocation.
• Where clients have a lot of wealth in one asset class, I might prepare a chart that shows how central that asset class is to their investment approach. For example, with a client who has a lot of rental properties, I might include a chart showing what proportion of their total wealth is tied up in property.

An example

Jack and Jill have worked hard and have had some good financial fortune. Their balance sheet looks as follows:

Consolidating their assets into a simple balance sheet can be revealing. Many people haven't ever done this. If that's you, give it a go!

From there, it's useful to feed your investment assets into a spreadsheet. Below is an example. Basically, I've listed all individual investments, put in how much is invested in each asset, allocated a percentage of each investment to growth and defensive assets, and also noted how each individual investment is split across different asset classes. When it comes to managed funds, I've used the "target asset allocation" for each fund, which is set out in their disclosure documents.

(Yes, I've included property as a growth asset, the same as shares. There's room for good faith debate, but I believe direct property shares much more in common, in terms of risk and return, then shares than, say, cash or term deposits.) 

Once you play around with the figures, you can start putting your asset allocation into visual form (ie, pie charts), and things get even more revealing.

Below is a chart that divides all of Jack and Jill's underlying investments into specific categories. (Note that this relates only to investment assets.)

I've tweaked the chart to split up the "direct property" section of the chart into "rental property 1" and "rental property 2" to see how much each property takes up of Jack and Jill's portfolio.

Below I've categorised all assets into two broad categories: "defensive assets" and "growth assets". 

One interesting aspect of Jack and Jill's situation is that they have a net worth of over $3.2 million, but a really significant proportion of it is directed towards personal assets (ie, their home and bach). The following chart compares personal assets versus investment assets.

This is probably fine for Jack and Jill. But there are opportunity costs to having such a high proportion of assets tied up in personal assets compared to investment assets, which might generate income. For some people, it's really important to point this out.

The following chart demonstrates how much of Jack and Jill's net worth (including personal assets) is invested in direct property, compared to other asset classes.

This is on the high side, but it might be fine for Jack and Jill. Having said this, they might not have thought about how concentrated their exposure is to residential property until they see it in such stark terms.

In this article, I'm not going to talk about the asset allocation that Jack and Jill should have. Ultimately, this is idiosyncratic to Jack and Jill, based on many different factors. But as you can see, putting their asset allocation into different contexts can help inform the way they think about their situation and the options available to them. 

Miscellanea

There are a few things to keep in mind when thinking about asset allocation in this way:

• You'll almost never be exactly correct with your calculations. This is especially the case with managed funds, and assets that change in value regularly. The value of shares and other assets (eg Bitcoin) can increase and decrease dramatically over short periods of time. Managed funds might have a target asset allocation, but can vary within their asset allocation quite significantly. (Some examples: SuperLife funds tend to hew fairly narrowly to target allocations. Simplicity funds can vary a bit, since the asset allocation for these funds tend to borrow from other equivalent funds on the market. More actively managed funds, like Juno, can diverge significantly from their target allocation.) When it comes to looking at your broader asset allocation, it's best to think in terms of being "broadly correct" rather than "precisely wrong". 
• Some people might want to go even more granular than above. It's one thing to have two overarching categories for shares – Australasian versus international shares. But you might want go into even more specific detail, distinguishing between shares on several different dimensions, such as countries of origin or industries they operate within (tech, financial, retail, utilities, healthcare, resources, healthcare, etc). Whether and to what extent you want to go into this level of detail is another discussion.
• Looking at your asset allocation in this way doesn't factor in leverage. There's quite a big difference between an investment portfolio that has $500,000 of borrowing versus the same portfolio that doesn't have any borrowing against it. This needs to be considered as an additional factor. 
• With respect to leverage, borrowing is often linked to one or two specific investments – in this case, the $500,000 Jack and Jill are strictly mortgages against their rental properties. However, in the broader scheme of things, they could use some of their financial assets to pay down some of their debt. Or they could have more debt and more financial assets. Ultimately, borrowing also needs to be seen in the context of your broader asset allocation and not just an individual asset or asset class. Jack and Jill's $500,000 of borrowing is effectively against their entire portfolio.
• You might need to be careful if you are consolidating assets held in different capacities. For example, a couple might hold personal assets, as well as family trust assets. Sometimes it might be appropriate to consolidate assets to get an overarching sense of their holistic financial situation. But it's something you need to be mindful of, especially if there are trusts with very different objectives and sets of beneficiaries.