STRATEGIC CONCEPTS: INVESTMENT & RISK

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1 ASSET ALLOCATION & RISK PROFILING What is Asset Allocation?» The distribution of your portfolio between the following asset classes:» R eturngeneration of any portfolio return, asset allocation is responsible for 85-95% of that return; specific investment selection makes up the remaining 5-15% i» R iskcontrol by allocating amongst the asset classes, including between domestic & international, asset allocation affects many of the different risks that are present in a portfolio The table below shows the two dimensions of returns from the asset classes: Understanding Risk Tolerance Your attitude to the likely outcomes of a given investment portfolio is often termed your risk profile or risk tolerance. It is the level to which you are willing and able to accept the possibility of an uncertain outcome being associated with your financial decisions which enables us to understand your investment attitude. We understand that most people consider themselves to be risk-avoiders rather than risk-takers, and any investment risk that we undertake is something that we all begrudgingly accept. It is like going to the Information correct at July 2014 Page 1

2 dentist. We very rarely meet any one that goes to the dentist more frequently than needed because they can tolerate the pain or discomfort. We go to the dentist, begrudgingly, because if we don t the consequences are far more painful. The same is true when investing. Our objective is to establish together how much risk you are willing to take, because at the end of the day that will determine what return is reasonable. Our process is designed to help you achieve your most important goals without needlessly sacrificing your lifestyle and while avoiding unnecessary investment risks. By understanding your risk tolerance you may be more accepting of a greater exposure to investments in growth assets such as shares and property. This can help in increasing the return on your portfolio and to combat against the ever-present effects of inflation. You are no doubt familiar with the saying, Nothing ventured, nothing gained, but generally people have difficulty applying it to their investment behaviour. It is perceived that there is a clear risk of major loss in the short term, whereas the potential gains are distant, vague and marginal. Often people choose safe alternatives based on short term considerations, not realising the damage this does to their long-term financial well-being. It has generally been observed that:» Share investments tend to be (marginally) more risky than property investments,» Property investments tend to be more risky than fixed interest investments, and» Fixed interest investments tend to be more risky than cash investments As investment professionals we agree with this hierarchy of risk; however we consider risk in terms of the volatility of each investment rather than the risk of losing capital. It also is accepted as a general rule that, over the long term:» Share investments will tend to outperform property investments,» Property investments will tend to outperform fixed interest investments, and» Fixed interest investments will tend to outperform cash investments. While there will be some periods, perhaps even years, where this rule does not work, there is abundant evidence that the rule holds over the long term. Risk Profiling & Psychological Testing The whole issue of financial risk is a difficult one. On the one hand, low risk tolerance prevents many people from doing as well as they could financially. On the other, some of life s most unpleasant financial surprises arise because people were exposed to a level of risk beyond their comfort zones especially if that leads to short term decisions which jeopardise the achievement of long term objectives. Information correct at July 2014 Page 2

3 Unlike say height or weight, there is no unit of measurement for risk tolerance. A person s risk tolerance can only be measured relative to others on an artificial scale (in much the same way as IQ is measured). Risk Tolerance is a physiological trait, as are intelligence, personality, aptitude, attitudes and values. A trait can be defined as any distinguishable, relatively enduring way in which one person varies from another. The Finametrica Risk Profiling system, which Mammoth uses to assist in understanding your own tolerance to investment risk, has been developed using widely accepted disciplines that apply to psychological testing. The answers obtained from your questionnaire are compared to a sample of the adult population to compare your investment attitude. Studies confirm that people generally do not accurately estimate their own risk tolerance. While the pattern of estimates is scattered, there is a slight overall tendency to under-estimate. To give a more accurate gauge of your risk profile and therefore what your investment strategy should consider, we asked you to complete this independent Risk Profile Questionnaire. FinaMetrica s Risk Profiling system was developed in conjunction with the University of New South Wales Psychology Unit using widely accepted disciplines that apply to psychological testing. Portfolio Construction Managing Volatility There are a number of ways we can help reduce or at least manage the expected volatility of your investment portfolio. Diversification is one of the most common methods and it relates to one of the more common investment adages around don t put all your eggs in one basket. We almost always suggest that you diversify both across different investment types and within different investment types. Across Asset Classes The overwhelming majority of our clients portfolios are invested across all of the asset classes listed below: Grow tha ssets» Property» Australian Shares» Global Shares Incom ea ssets» Specialist Cash Investments» Australian Fixed Interest» Global Fixed Interest Diversification within Asset Classes We aim to position your portfolio so that it is diversified across industries, companies, countries and currencies, unless it is your specific wish to maintain a more focused portfolio or there is a specific benefit for you in maintaining a more focused portfolio. This should ensure that your investment portfolio will not Information correct at July 2014 Page 3

4 be over exposed to one sector within an asset class (for example, within shares having all your share investments in the banking sector). Examples of diversifying within an asset class are:» Across industries» Across countries/regions» Across investment managers and investment styles» Across currency» Across dependence on the economic cycle The reason why diversification is so important is that historically, no single asset class has consistently outperformed all others every year. Investing across a variety of asset classes reduces the volatility of your portfolio return and helps achieve the investment outcome you require. Annual Return of Each Asset Class As shown in the table that follows, in the long term portfolios that incorporate growth assets have the potential to grow substantially. However, investment markets also have the potential to go through long periods of weak performance which could result in your portfolio losing value, even over a period of several years. When accepting your investment, you need to be aware of all possible outcomes, and not just those over recent history. Understanding the potential variations in the value of your portfolio from time to time will prove invaluable for your long term outcomes as it will assist you with avoiding the mistakes that many investors make when their emotions get the better of them. Skilled investors avoid these mistakes because they do not get caught up in the emotions of investing, which often results in poor decision making. Skilled investors remember that markets have always experienced periods of negative results and they have always recovered and gone on to reach further new highs. However there are no guarantees that this will definitely always be the case Our clients have repeatedly told us that one of the most valuable benefits we provide to them is a clear and rational point of view in times of uncertainty that helps prevent them from making the mistakes that many investors make. The table below provides the returns for each of the major asset classes for each 12 month period for the year shown to 30 June. In the three right-hand columns we have also included an analysis of the following investment approaches:» ChasingW inners in this hypothetical scenario, on 1 July each year the investor looks at the returns for the past 12 months and switches their total investment into the asset class which had the highest return for the prior 12 months that is, they chase last years winners. Regrettably this isn t only a hypothetical example; fund investment flow information confirms that plenty of investors, and even more worryingly, their advisers, behave in this manner» ChasingL osers in this hypothetical scenario, on 1 July each year the investor looks at the returns for the past 12 months and switches their total investment into the asset class which had the lowest return for the prior 12 months that is, they chase last years losers. While this approach Information correct at July 2014 Page 4

5 has more merit than the Chasing Winners strategy because at least they are not buying assets at their highest values, this still provides for a very volatile ride» Grow thp ortfolio in this scenario, this investor determines that their level of risk is Growth and determines an appropriate combination of all asset classes which will provide results within the bounds of their risk tolerance and they then maintain this asset allocation throughout the market cycle. Accordingly they are invested in all asset classes at all times (unlike the chasing winners and chasing losers approaches) Note: the best, worst and average returns are for the asset classes for the period from 1971 to 2014 where available and from 1986 to 2014 for the strategies discussed above. Please note that past performance is not indicative of future performance. The strategy of switching to last years worst performing asset class has provided the highest average return over this 28 year period which would therefore have resulted in a higher level of assets at the end of the period, closely followed by the strategy of switching to last years best performing asset class. However as shown by the very wide range of returns in both the Chasing Winners and Chasing Losers strategies, this could change dramatically in any year. It is also important to note that this analysis excludestransaction costsandcapitalgainstax, both of which may be payable every year in either of the two chasing strategies (thereby further reducing the net returns for those strategies) and significantly lower by utilising the growth strategy. Information correct at July 2014 Page 5

6 For the purpose of the above analysis, the following asset allocation has been assumed for the Growth Portfolio: In any case the range of returns for both of the chasing strategies is significantly wider than that provided by the Growth, indicating lower volatility and more consistent returns. TYPES OF RISKS T ypesofrisks Provided below is a high level summary of the key risks that will apply to many financial strategies and financial products. Please refer to the appropriate Product Disclosure Statement for risks that apply to any particular product and to your Statement of Advice. W ilyou outliveyourcapital? L ongevity R isk There is a risk of living too long. In other words, if you are using the capital of your investments to live on, you could outlive the value of your capital. It is a fact that people are living longer due to improved lifestyles and medical techniques. For this reason it is important that you have investments such as shares or property that gives you capital growth and therefore a greater potential for continued income. Statistically this is the largest risk that Australian s face as very few are able to retire with complete financial security in retirement. Risk Inflation Risk Interest Rate Risk Market Risk Explanation The real purchasing power of your money may not keep pace with inflation. Inflation is an important consideration for all investors, how everespecialy forretirees. If the after tax return on your investments is less than the rate of inflation, then the real value of your money (i.e. what it can buy) will decline. Specifically, Term Deposits do not protect your capital against inflation risk For investors relying on fixed rate investments, maturing money may have to be reinvested at a significantly lower rate or rates may rise after you have locked in a lower rate Movements in the market mean the value of your investment can go down as well as up, sometimes suddenly. Different types of investments experience different levels of volatility. Volatility becomes a problem if you do not have the time frame to withstand the rough patches. It is important to remember that markets go through regular ups and downs and that capital losses occur only if Information correct at July 2014 Page 6

7 Asset Specific Risk - Risk of not Diversifying Market Timing Risk Credit Risk Liquidity Risk Legislative Risk Mismatch Risk Fund Manager Risk Risk of not diversifying market risk Reinvestment risk Currency risk Counterparty Risk investments are redeemed when markets are down. While it is tempting to sell out of an investment after its value has fallen, history has taught us that investors who stick with their strategy generally go on to recover and prosper. All your capital will be affected if your single investment does badly. Diversification means spreading your money across different investments to reduce risk. The right asset allocation is an important driver for the long-term returns of your portfolio. Anticipating market rises and falls can be extremely difficult because no two economic cycles are the same. Seeking to time investment markets has repeatedly been shown not to be a sound long term approach which tends to result in an overall poor return and high transaction costs. A sensible diversified portfolio maintained throughout the market cycle will generally outperform a continually changing portfolio, with lower risk. This applies to debt type investments such as term deposits and debentures. The institution you have invested with may not be able to make the required interest payments or repay your capital. You may not be able to access your money quickly, or without cost, when it is required. This is particularly the case with certain property, mortgage, hedge fund and fixed interest investments. Your investment strategy could be affected by changes in the current laws and regulations. The investment you choose may not be suitable for your needs and circumstances. A perfectly sound investment choice for you now may not be best for you at another time. The risk that the fund manager you invest with may not perform according to your expectations. We reduce this risk by only recommending a complimentary range of reputable fund managers and investment professionals who meet the stringent criteria of our research process & regularly considering their ongoing suitability for you The possibility that if you put all your investment capital into one basket (e.g. the share market) a fall in that market will adversely affect all of your capital. Diversification is a deliberate strategy aimed at reducing the impact that volatility in one asset class, sector or single product will have on your overall portfolio of assets. The possibility that if you invest in fixed rate investments you may have to reinvest maturing money at a lower rate of interest if rates declined during the life of that investment. This is especially a risk of Term Deposits The possibility that investments held in other countries may rise or fall in value due to the relative value of the currency they are held in to the domestic (Australian) currency. The risk that the counterparty to a transaction that you engage in is unable to fulfill their obligations under the transaction. This includes borrowers being unable to repay funds that you have lent them (for example with fixed interest securities), insurance companies being able to pay legitimate claims and many others Further information regarding risk and return can be found in the Investment Management and Resources sections of the Mammoth Financial website, as well as on other websites including the Australian Securities & Investment Commission s (ASICs) consumer website DOLLAR COST AVERAGING MANAGING TIMING RISK Dollar cost averaging takes some of the risk out of investing in fluctuating markets because it removes the factor of deciding when to invest. The basis of dollar cost averaging is that you invest a set amount on a regular basis, no matter whether the market is up or down. Importantly, this is a natural and key benefit of our super system whereby employers are required to make contributions quarterly irrespective of investment values. Information correct at July 2014 Page 7

8 There are three main advantages to this:» Investment markets fluctuate and it is therefore difficult to choose the best time to invest. By investing on a regular basis, the risk of investing at the least favourable time is reduced.» By investing the same amount each month, you can actually take advantage of market fluctuations. When the market is up, the value is higher and your money will buy fewer shares. When the market is down, the value is lower and you will buy more shares.» Establishing a plan in advance removes the risk that emotions affect investment decisions, which is a key reason why actual returns received by investors differ from the long term, end to end returns of the underlying investment Here is an example of how this can work for you. Month $ Invested $ Unit Price No of units $ Cumulative Value purchased January February March April May June July August September October November December Total In the above example, an investment of $12,000 throughout the year provided a return of $3,923. If $12,000 had been fully invested at the start of the year, the end value would be $13,800 - a return of only $1,800. Both of these return amounts are before any fees and taxes. Apart from the benefits of dollar cost averaging, a regular investment plan offers several advantages including the ease of maintaining discipline as regular investments can be debited from your bank account each month. empowering your financial evolution TM Need more information? Please feel welcome to contact Mammoth Financial on: p e alex@mammothfinancial.com.au General Advice Warning: The advice may not be suitable to you because it contains general advice that has not been tailored to your personal circumstances. Please seek personal financial advice prior to acting on the information. Tax Agent Warning: We are not registered tax agents under the Tax Agent Services Act If you intend to rely on the advice to satisfy liabilities or obligations or claim entitlements that arise, or could arise, under a taxation law, you should request advice from a registered tax agent. Information correct at July 2014 Page 8

9 Opt Out Clause: Mammoth Financial respects your privacy. Should you wish not to receive further publications please contact our office. i (Sources: Brinson, Gary P., L. Randolph Hood, and Gilbert L. Beebower Determinants of Portfolio Performance. Financial Analysts Journal, vol. 42, no. 4(July/August):39-44; & Vanguard Index Chart 2014: The Importance of a Long-Term Vision, Vanguard Investments Australia Limited, 30/07/2014 Information correct at July 2014 Page 9