Having too much of your future retirement income tied up in just one or two investments is highly risky as markets change and investment returns go up and down. Furthermore, you need to consider spreading your investments over different asset classes to further minimise the loss of potential income.
So What Are The Different Asset Classes You Can Invest In?
There are primarily four types of asset classes categorised into either defensive investments or growth investments. Defensive assets focus mainly on generating income and growth investments focus on both capital growth and income.
1. Cash Asset Class (Defensive Asset)
Cash investments can include bank deposits, term deposits, savings accounts and cash management trusts. They are suitable for short term growth and can provide a low risk and stable income. However their potential returns are also lower than other forms of investments.
It is important to note though, that under the ATO guidelines, a SMSF must hold a certain amount of its investment portfolio in easy to access cash. This is so the fund can pay its administrative expenses and any income tax when these expenses become due.
2. Fixed Interest Asset Class (Defensive Asset)
Fixed interest investments include government bonds, corporate bonds, mortgages and hybrid securities. They are relatively stable but slightly more volatile than cash investments.
Their potential return is moderate and comes in the form of regular interest payments. The minimum suggested time frame for this asset class is one to three years.
3. Property Asset Class (Growth Asset)
Property investments can include the direct purchase of residential, commercial and industrial property. They can also include indirect investments in listed properties such as REITS. Listed properties generally consist of a professionally managed portfolio of different types of real estate in which investors purchase shares.
The potential return for property investments is moderate to high but this depends on the property market and the fund’s ability to hold onto the property until a good selling price can be obtained.
Generally, an SMSF should hold onto any property it owns for a minimum of 7 years however it is wise to keep the property investment until the member/s reach retirement age to obtain the most benefit from the capital growth.
4. Equities Asset Class (Growth Asset)
This type of investment class includes both Australian equities and International equities which are more commonly known as shares. The potential return for shares can be high but the risks are also high as these can be quite volatile.
With shares, income is generated through the dispersion of dividends when the companies invested in make a profit. Shares are also able to achieve capital growth as share prices can go up or down depending on the stability of the market.
When investing in foreign equities, the SMSF trustee must also be aware of currency fluctuations as these can determine how much income the shares will generate in any given period of time.
Why Diversification Over The Different Asset Classes Is So Important
It is quite common knowledge that any type of investment will go through a natural cycle of boom and bust. This can best be illustrated by the Economic or Investment Clock which first appeared in England in 1937.
Primarily this clock illustrates the economic cycles that dictate whether investments are in a growth phase or whether they’re currently in decline.
Diversifying your SMSF portfolio across different asset classes means that when one asset class is in decline, another one may be on the rise and therefore, this minimises the risk of your portfolio losing money.
This type of investment strategy has also historically shown to yield much higher returns than one which only focuses its investments on one or two asset classes.
How Can You Ensure Your Portfolio Is Sufficiently Diversified?
Here are some guidelines on ensuring that your SMSF investment portfolio is adequately diversified.
1. Spread Your Investments Over Different Asset Classes
We’ve already discussed that it’s important to spread your investments over the four different asset classes, however you should carefully consider how much you invest in each class.
Consider investing in more stable investments like cash assets using a larger percentage of your portfolio and only allocate a smaller portion, say 5-15%, to the highest risk asset classes. Then spread the rest of your portfolio over the more longer term growth asset classes like property.
This will help to manage your overall investment risk but still provide your portfolio with good returns.
2. Make Sure That Your Share Portfolio Is Adequately Diversified
Try not to limit your purchase of shares to just a small number of companies. The more diversification you have, the more chance you’ll also have of getting good returns and minimising any losses.
3. Consider Investing In Exchange Traded Or Managed Funds
EFTs allow you to invest across many of the asset classes with just one or more trades. They are easily tradeable and relatively low cost.
Managed funds, on the other hand, are invested in a number of different asset classes by professional investment managers. These could include offshore property, local or international shares or infrastructure.
Now that you understand the importance of diversifying your SMSF investment portfolio you should consider making yourself familiar with all the different investment options at your disposal.
Ultimately, it’s highly advisable that you seek the advice of an investment professional, speak to your financial planner or even your accountant. Try to get as much knowledge as you can even if it means speaking to more than one professional.
After all, it’s your retirement nest egg and is meant to provide you with a comfortable lifestyle once you retire so that you can enjoy it without having to worry about how you’re going to fund it.