When it comes to superannuation, you may think of it as a savings account for your retirement, but it’s much more than that. It allows you to grow your savings over time through a carefully constructed investment strategy. This article explains two core investment principles that drive that strategy - diversification and asset allocation - to help you make more informed decisions and construct a portfolio designed for the long term.
What is diversification?
All investments involve some level of risk. An important way to help manage these risks is to ensure that the investment strategy you choose includes investments that are diversified across a range of characteristics. Diversification may be achieved in various ways, including investing in different asset classes, market sectors, geographical regions and investment managers.
Diversifying your account across a broad range of asset classes may smooth returns while still providing the opportunity for capital growth. An easy way to achieve diversification is to invest in multi-sector managed investments, where you gain exposure to a range of securities in different asset classes. A financial adviser will be able to recommend investments that suit your personal circumstances.
A lack of diversification arises from investing a large proportion of your account in one asset or the same type of investment. This can increase the risk of losses and may reduce your retirement savings over time.
What is asset allocation?
Asset allocation is the process of deciding how to split your money across different types of investments, known as asset classes. These asset classes are typically grouped into two main categories based on their risk and return characteristics – defensive and growth.
- Defensive assets (eg. cash and fixed interest investments) typically provide stability and regular income, making them a lower risk component of a portfolio. However, their capital value does not typically increase significantly over time.
- Growth assets (eg. Australian shares, international shares and real assets like property and infrastructure) have the potential for higher returns over the long term, but also come with higher risk and volatility. These assets are generally held to achieve capital growth, but they may also offer varying combinations of growth and income.
By combining these asset classes in different proportions, you can create an investment mix that aligns with your financial goals and risk tolerance.
Are asset allocation and diversification the same?
While related, asset allocation and diversification are not the same thing. It’s possible to have an asset allocation that is not well-diversified. For example, a portfolio split between cash and Australian shares has an asset allocation, but it lacks diversification. True diversification involves investing across a number of different asset classes, and then also diversifying within each of those asset classes.
Why is this important for your retirement?
A well-thought-out strategy using both asset allocation and diversification is essential for managing the risks of investing and achieving your long-term objectives.
- Managing risk: Investment markets tend to move in cycles, and different asset classes and investments may perform differently at different times. When one asset class or part of the market is down, another may be up. By spreading your investments, you can mitigate the impact when one sector or region experiences a downturn, leading to less fluctuation in your portfolio's value.
- Achieving long-term growth: While keeping your super in defensive assets might seem safer, the returns are typically low and may not keep up with inflation. A diversified portfolio with an appropriate allocation to growth assets gives your super the potential to grow faster than inflation and support you for longer in your retirement.
- Promotes disciplined investing: A structured, diversified portfolio helps remove emotion from your decisions. Knowing your strategy is designed to handle market volatility can give you the confidence to stay the course and avoid reactionary decisions, like selling at the wrong time.
Determining your strategy
When it comes to developing an appropriate investment strategy, there is no ‘one-size-fits-all' solution. The strategy you select will depend on your personal circumstances and it should be reviewed regularly.
Your strategy may evolve over time
Your investment strategy should be regularly reviewed so that it remains suitable as you move through different life stages.
- Early in your career, with decades until retirement, you may wish to consider positioning your portfolio for greater growth. This typically means a higher allocation to growth assets, as you have more time to recover from any market downturns.
- As you approach mid-to-late career, your focus may gradually shift. While growth remains important, protecting the capital you've accumulated may become a higher priority. This could involve progressively reducing your allocation to growth assets and increasing your holding of defensive assets. This process helps to secure gains and reduce the risk of a significant market fall immediately before your retirement.
- Once in retirement, your strategy may shift again to support your income needs while managing risk to ensure your capital lasts throughout your retirement years.
Your tolerance for risk
Your personal capacity to handle market fluctuations is another essential factor. Understanding how comfortable you are with risk is key to selecting a strategy you can commit to for the long term.
Take the next step
Constructing an effective investment strategy is a critical step in preparing for retirement. We encourage you to seek guidance from a qualified financial adviser who can help you develop a personalised plan that aligns with your goals and financial situation.
