Calculating the required rate of return is a key step in assessing what it will take to get to your objective. Along with continuing to save and invest, the return you earn on your investments are what will get you to your goals. The biggest influence on the returns you earn will be how you allocate your portfolio and any future savings.

Read below to discover three steps you can take this January to make sure you are on track to achieve your financial goals. 

Step 1/3—Why asset allocation matters

We should start by stating the obvious - asset allocation is not exciting. Your mates are not going to be hanging on your every word at the BBQ as you describe the percentage of your portfolio allocated to listed real estate. While this might not be first date material, asset allocation has a huge influence on the returns that you earn. Professor and investor Roger Ibbotson stressed this importance when he said, “On average, 90 percent of the variability of returns and 100 percent of the absolute level of return is explained by asset allocation.”

Asset allocation simply refers to what assets make up your portfolio. The combination of asset classes you select has an enormous influence on your returns. Investing, after all, is simply the exchange of risk for returns. Meaning that putting more of your portfolio into riskier assets—such as shares—means that your portfolio will have higher expected returns. In exchange for taking on this risk you may suffer higher volatility. Meaning the value of your portfolio will bounce around more and can experience sharp and prolonged losses. 

Below are some resources to help:

Step 2/3—Set an asset allocation plan that is right for you

If you’ve never put much thought into asset allocation there is no time like the present. This is where the required rate of return comes in. The asset allocation of your portfolio should be based on your personal circumstances. This is a theme you will hear a lot from us at Morningstar. Investing is about you—your goals, your future and consequently, your own asset allocation target. The higher your required rate of the return, the more growth assets need to be in your portfolio.

Growth assets include shares, listed property and infrastructure, while defensive assets include fixed interest and cash. Include both domestic and international investments across each of these categories. To determine what percentage to allocate to each asset class takes a little nuance. We provide Premium subscribers with 5 pre-defined asset allocation models based on different risk and return profiles.

Another approach is to review historic returns for some perspective into return and volatility of different asset classes. Using our ETF screener and select passive investments for each asset class can show you historical performance. Just be mindful that past returns may not occur again in the future. This is more than a disclaimer, listen to our podcast episode to hear why we believe it is highly unlikely that future returns can match historical returns across almost all asset classes.

Step 3/3—Rebalance your portfolio

Rebalancing your portfolio is one of those beneficial habits—like flossing every day—that’s easy to let slide. But if your portfolio’s equity exposure crept up over the past few years, a sudden market correction can be a harsh reminder of why it’s a good idea. 

As markets fluctuate your asset allocation can deviate from what you’ve originally set to accomplish your goals. If your allocation to growth assets become higher than planned, you may be taking on too much volatility risk. If your allocation to growth assets becomes too low, you may not be taking on enough risk to achieve the returns needed to accomplish your goal.

The first step to rebalancing is to see where your portfolio is currently allocated. The combination of setting up a portfolio with Sharesight (included free with a Morningstar Premium subscription) and our X-ray tool can provide a snapshot of where you stand. Now you simply need to compare the asset allocation plan you believe will enable you to achieve your goals to where you currently stand.   

Rebalancing simply means returning your asset allocation back to your original plan. If you wanted 40% of your portfolio in Aussie equities and a strong market had pushed your allocation up to 50% than it might be time to rebalance. Rebalancing is not without a cost. There are transaction fees and because you are selling assets that appreciated you are subject to capital gains taxes. As a result, rebalancing should only occur either periodically at set intervals like once a year or when allocations to specific asset classes have shifted a set percentage away from target, say 10 percent.