BT: Don’t forget to diversify

So you have a million dollars to invest. Let’s start by making some general assumptions; you own the property you live in, have no outstanding debts, you’re under 50-years-old, and in good health.

Now, let’s look at some options.

If you invested a million dollars into the Australian share market a year ago, your investment would have climbed by 22.7 per cent. A stellar 12-month gain especially compared to other asset classes such as US equities, global bonds or cash (returns were 6.8 per cent, 6.5 per cent and 5.7 per cent respectively).

However, as the economic cycle turns, so too do returns. Ten years ago the most favourable annual returns were delivered by US shares (up 23.1 per cent), global bonds (up 17.8 per cent), cash (up 7.9 per cent) and Australian equities (up 6.7 per cent).

Determining which asset class will outperform another is not an easy task, especially when you consider the variety of investable markets and industries. Let’s face it, if, over the next five years, the best returns were achieved by the Japanese property sector or by US corporate junk bonds, would investors be overly surprised?

Further, if you believed Brazilian coffee stocks were about to rally like they’ve never rallied before, would you invest all of your money into the industry? So what’s the answer? Diversification.

Diversification ensures an investor can still benefit from the highest performing asset class at a given time, while reducing overall risk by not being 100 per cent invested in an asset class or security that underperforms over a period of time. With a million dollars to invest, where can an investor look?

For an Australian-based investor there are significant tax advantages, through the use of franking credits and reduced capital gains tax, to encourage a reasonable allocation to Australian equities. Industries we favour include the resources sector, particularly BHP and Rio Tinto, gaming and healthcare.

What about global shares and listed property trusts? The recent securitisation of property markets in Asia and Europe has led to the introduction of global property as an interesting potential addition to an investor’s portfolio — particularly given its lack of correlation with more traditional asset classes.

In particular, the growth expected in the Asian property sector is enormous and should provide lots of opportunities over the next few years. Investors could also consider an allocation to the defensive asset classes of both domestic and international fixed interest.

About $100,000 could be a reasonable allocation to alternative investments, including private equity, hedge fund of funds, commodity funds, or essentially anything that has little performance correlation to traditional asset classes.

These types of funds seek to deliver positive returns regardless of the market environment. More importantly, over the long-term, performance expectations are in line with long only equity funds, with risk more aligned to that of the bond market — interested? One word of caution, these investments tend to have reduced liquidity.

With this in mind, an investor with at least a five-year timeframe and a reasonable risk appetite might consider investing 35 to 40 per cent in Australian equities, 15 to 20 per cent in international equities, up to 10 per cent in property (domestic and global), 20 to 30 per cent in fixed interest (domestic and global), and up to 10 per cent in alternative assets.

If a million dollars was invested in a high growth balanced fund like the one described earlier, we’d expect to see long-term average annual returns of around 8 to 10 per cent.

While not as impressive as the returns delivered by the Australian share market last year, let’s not forget about the other important component of the risk return trade-off — risk from a diversified strategy is much lower versus the risk found in a single asset class.

Debbie Alliston is head of investments at BT Financial Group .