Learning about shares: Spreading your money can keep risks in check

Olympic champ BARBARA KENDALL gets help from NZX's Dan Dividend

Q. Barbara asks: Now that I'm starting to build up my portfolio, I'd like to start diversifying into investments other than shares. Can you explain what asset allocation means?

A. Dan Dividend responds: Asset allocation is a fancy phrase for a simple concept: it means spreading your money between different types of assets such as shares, debt securities (fixed-interest investments, including bonds) and cash.

It's an investment technique that aims to balance risk and create diversification. Each type of asset has a different level of risk and return and behaves differently over time.

The basic principles of asset allocation are based on the idea that your combination of assets should always reflect your goals.

Let's start with some quick definitions. We already know what shares are, but debt securities are investments we haven't introduced yet. Although we'll cover them in detail later in the series, now is a good time for a quick primer.

Companies issue debt securities (such as bonds or capital notes) to raise money for expansion, or a takeover, for example.

When you purchase debt securities, you lend the company money and the company takes on a debt to you, hence the name.

On a pre-determined date, called the maturity date, the company must pay your money back.

During the life of the debt security, the company pays you interest at a set rate. These payments are called coupons. This is where the term "fixed interest" comes from.

Money in the bank would fit into the cash category.

These three categories, being completely distinct from each other, gain or lose value in response to different factors.

What mix of assets should you choose? I'll call on this week's guest NZX broker, Shanta McPherson from Forsyth Barr in Dunedin, to discuss practical asset allocation principles.

* Shanta says: As Dan has mentioned, your combination of assets should reflect your goals and your situation in life. It's all about balancing investments with varying degrees of risk in a way that suits you.

The sharemarket has historically been the best place to put your money for great returns, but that return comes with a certain degree of risk caused by short-term price volatility.

Debt securities, with their guaranteed interest payments, are regarded as lower risk than shares. However, the trade-off for certainty of income is generally lower returns.

We'll consider how people in three age groups might divide their assets.

The young professional

Investors in their 20s and 30s tend to look for great capital gains over a long timeframe. They are often comfortable with taking on more risk with the aim of getting higher returns.

Many young professionals therefore invest heavily in shares, with a small proportion of fixed-interest investments to give extra diversification. They might also have some cash in the bank for new investment opportunities that might arise in the sharemarket.

The middle-aged investor

Many middle-aged investors' goals have changed since their younger days. They may still be looking for good capital gains to build up their retirement savings or help their children through university, but they may want to lower the overall risk of their portfolio to protect their savings.

Depending on their individual tolerance for risk, middle-aged investors could build a portfolio that reflects a fairly equal balance between shares and fixed-interest investments.

The retired investor

People in this age group may invest more for income than capital growth and are often concerned with protecting their money against risk.

A retired investor's portfolio could therefore include a higher proportion of debt securities than any other category, and enough spare cash to meet spending requirements. They might also include some shares to provide extra returns and assist the income they get from their fixed-interest investments.

It's important to bear in mind that these are guidelines only and many people do not fit into these categories.

You should talk to an adviser at an NZX firm who can help you figure out an appropriate mix of assets for your individual circumstances and goals.

NEXT: What's an exchange-traded fund?


GOT A QUESTION?: Feel free to email Dan Dividend with your questions