Starting From Scratch: Risk, Return and Diversification

Starting From Scratch - Week 2: Risk, Return and Diversification

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Last week we covered where to start. This week, we’re turning our attention to asset allocation and risk tolerance, two key factors that influence how your portfolio performs and how comfortably you can stay invested through market ups and downs.

Many investors have a story about an investment that went the wrong way, or a friend who got burnt. It’s easy to take that away as “investing is dangerous” and leave it there. But risk isn’t something to avoid at all costs. It’s something to understand.

Start with the purpose, not the product.

Before choosing what to invest in, ask what each pool of money is for and when you’ll need it. How your money is split between cash, fixed interest, property and shares is called asset allocation, and it should be built around your goals and timeframes.

A First Home Deposit (short term) for a 25-year old, and their superannuation (long term) potentially has a different timeframe for the investment, therefore a separate investment strategy and allocation to different asset classes as a result

Ability and willingness.

Risk is also about the individual, and there are two sides to the risk someone is willing to take:

• Ability: Do you have enough time to ride out the market’s ups and downs?
• Willingness: how comfortable are you seeing your balance move around?
  
  

Individuals can have the ability to take more risk and still not want to, and that matters just as much.

The main asset classes.

Defensive assets: the gentle train ride.

Cash and fixed interest (lending money to governments or companies in return for interest) tend to be steadier, with more predictable and lower returns as a result.

Growth assets: the rollercoaster.

Shares and property aim to grow your money over time, but their value can swing around a lot more. Property is tangible, but it comes with higher entry costs like stamp duty and agent fees, and it’s harder to sell. Shares are generally cheaper to get into, easier to manage and easier to sell, which makes them a more accessible starting point for many people.

The quiet risk of too much cash.

Cash feels safe, but too much of it for too long can cost you. Say your savings account earns 4.9% and inflation is running at 6%. Your balance goes up, but what it can actually buy goes down by about 1.1%. Prices rise over time, and savings that don’t grow with them lose ground.

Prepare for the downturn before it happens.

Markets will fall at some point, as they did in the global financial crisis and during COVID. The time to plan for that is beforehand. Imagine your shares fall by 30%. That turns $100,000 into about $70,000. How would you react? Some people sell and move to cash, while others see lower prices as a chance to invest more. The right mix is the one that suits how you would really behave, so you’re less likely to make a reactive decision, like selling at the bottom.

Diversify, but know what you own.

“Shares” and “ETFs” aren’t single, uniform categories. Within shares you can spread across countries (Australia, the US, Japan, emerging markets) and sectors (like financials, materials and consumer goods). Australia makes up only around 2% of global share market value, so investing only here means missing out on most of the world’s companies. The aim is to spread your risk without becoming concentrated in one area, and to understand what each holding contributes.

Jargon buster

Asset allocation: how your money is split between cash, fixed interest, property and shares.

Defensive assets: investments like cash and fixed interest that aim for stability.

Growth assets: investments like shares and property that aim to grow in value over time.

Volatility: how much an investment’s value goes up and down over time.

Inflation: the rising cost of goods and services over time.

Compounding: earning returns on your past returns, so growth builds over time.

Homework for the Week:

Log in to your super and find out how much is in growth assets versus defensive assets. Many funds place members in a default option, so it may not be a choice you’ve actively made. Then write a line on how you’d honestly react if your investments fell by 30%: sell, hold or buy more? It’ll make next week’s episode a lot easier to apply to you.

This series is a starting point to help you make more informed decisions. If you’d like help choosing investments or building a plan around your goals and timeframes, speaking with an adviser can help.

Next week: Behavioural finance, and how our own experiences and reactions to market movements can shape our investment decisions.