Revisiting asset allocation for the new normal as cycles turn

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MEDIA RELEASE: Investors may need to revisit their traditional balanced’ investment option in coming years, as the market cycle turns and overall returns reduce, says Jonathan Philpot, wealth management partner at HLB Mann Judd.

“The ‘balanced’ default asset allocation option is the way many people are invested in superannuation.  Typically this is an asset allocation of 70 percent to ‘risky’ investments – such as shares that experience large swings in market value – and 30 percent to ‘secure’ investments – those that have less volatile pricing movements such as fixed income.

“It’s a strategy that has served super fund members well in the past few years as super funds have delivered very strong returns. 

“Shares in particular have performed well with the lower interest rates leading to double digit returns over the past three years.  Even the ‘secure’ part of the portfolio has performed well as bonds have benefited from an environment of falling interest rates,” Mr Philpot said.

But he questions whether this strategy will serve investors over the next five years.

“A ‘balanced’ investor is unlikely to continue to receive such strong investment returns as interest rates hit the bottom of the cycle. 

“In particular, the poor outlook for ‘secure’ or fixed interest investments is a concern and a 30 percent allocation may be too high in this low return environment.

“It is hard to predict interest rate movements, but it is fairly safe to assume that interest rates over the next five years will not rise by more than 1 or 2 percent. We can expect 1 year term deposit rates to remain under 3 percent and other secure fixed interest type of investments to be providing similar type of returns.

“This means the balanced investor with a 30 percent allocation to fixed interest investments may only receive a return of 3 percent for this part of the portfolio for the next five years.”

Meanwhile, Mr Philpot says medium term returns of 7-8 per cent – made up of dividend yield and earnings growth – over the next five years would be a reasonable expectation for share investments. 

“With a 70 per cent allocation to shares and a 7-8 percent expected return, the balanced investor is likely looking at a total return of between 5.5 and 6.5 per cent for the next 5 years; significantly less than previous years.

“For investors who are drawing down more heavily from their superannuation, this return may be too low.

“One solution to increase the investment returns is to increase the allocation to the ‘risky’ part of the portfolio. An extra 10 percent allocation is likely to produce a 0.5 percent higher return. But of course this comes with increased volatility and investors need to consider this carefully.

“Sharemarkets will continue to operate in the same volatile manner, which can be a daunting prospect for investors who are not used to the wilder ride.

“But while a 15 percent short term market correction on a higher proportion of an investor’s portfolio may be a difficult pill to swallow, for the benefit of higher expected long term returns, it may be necessary to achieve a longer lasting superannuation balance,” Mr Philpot says.