Asset Allocation that considers Asset Weighted Returns

My earlier posts on asset-weighted returns got me thinking about how to apply this thinking throughout the working life of a superannuation member so I did this little exercise. I know this has probably been done to death by the lifecycle investment gurus out there but I thought I’d see for myself what I would come up with…its a little dodgy but approximately ok.

Anyway, I thought I’d start with an 18 year old with no super, earning $20,000pa. Obviously 9% must be contributed to super under Australian law, and I also assumed his/her income would grow at 4%pa which is roughly in line with average growth rates in AWOTE (Average Weekly Ordinary Times Earnings…I think). I also assumed that the superannuation investment would grow at an annual rate of 7%pa after tax, which is obviously well above the risk free rate but over a working life of more than 40 years I’d like to think is achievable for a ‘balanced’ investment across multiple asset classes.

A summary of these simplistic results are in table 1 below…

Table 1

Now, obviously in the real world one’s income will fluctuate, therefore so will superannuation contributions, and investment returns will also fluctuate (don’t I know it!!). But, overall the outcomes from Table 1 don’t look too unreasonable.

Step 2 for me in this exercise is to consider ‘Value at Risk’ or VaR. Whilst VaR is a concept that has been blasted in recent times thanks to its mis-applicaton leading up to the GFC, its still not a bad way of looking at downside risk potential.

Using various risk and return assumptions, across generic portfolios ranging from 0% risky assets to 100% risky assets, I then calculated VaR for each portfolio…my definition is that the portfolio has a 1 in 40 chance of returning lower than the VaR result. For example, for a 70% risky asset portfolio I calculated it has a 1 in 40 chance of achieving a return worse than -10.5% in any one year and for a 30% risky portfolio a 1 in 40 chance of returning worse than -3.8%…you may think I’m being a little optimistic but sobeit they’re not too far off.

Using this information I then made the assumption that using the outcomes from Table 1 for each year from age 18 to 65, I do not wish to have more than $40,000 at risk (that is a 1 in 40 chance of losing more than $40,000).

Now I know I should have used some optimisation techniques with regards to my inputs but in keeping things simple I kept my balance figures from Table 1. Using my calculated VaR results for each portfolio, Chart 1 shows what the maximum exposure to risky assets needs to be throughout my example’s working life.

Chart 1

 As can be seen this chart has a very similar glide path that many of the lifecycle gurus spruik. Maximum exposure to risky assets does not start to decline until around age 47 and at age 65 the maximum exposure to risky assets is around 35%.

These outcomes can easily be adjusted on an individual basis depending on risk/return expectations, super contributions, as well as how much super balance one wants to put at risk over time. But these results use my rough estimates.

We all experience asset weighted returns…i.e. it hurts more when we lose more money…so…bottom line…if we consider asset-weighted returns when designing asset allocation for a superannuation member the evidence supports a lifecycle/glidepath approach to investing superannuation.

Good to see the MySuper legislation considering the lifecycle approach.

   Send article as PDF