Generating retirement income is the work of a lifetime. Starting as early as possible is important, but maximising returns is another crucial factor in determining investment success.

Most investors are aware of the power of time. The longer the time-frame the greater the benefit of putting earned income to work alongside initial capital. This compounding of returns is the secret to wealth generation.

Less well understood is the impact over the long term of marginal changes in returns on investments. Consider a couple aged 25. Both receive a $1,000 bonus. Both decide to invest for their retirement at age 65. One invests for the full period at 5%, the other at 6%. Interest is credited each year.

When their ultra-long deposit accounts finally mature the 5% investor is pleased to see that the original $1,000 has grown to $7,040 over the forty years. However when the 6% investor reveals that their account balance is $10,286 partner A is somewhat disgruntled. “Why didn’t anyone tell me how just a 1% increase can make such a difference?”

Many studies show that the asset allocation decision is one of the most powerful contributors to returns. How investors divide their capital between property, shares, bonds and other asset classes is vital.

The next step in determining investment success is the exposures within asset classes. Residential or commercial property? Which share market sectors? This is critical as a well-thought out investment framework can result in an exponential increase in investments over long periods of time.

Turning to share investment for locals there is a particular challenge. The sectors of the Australian share market vary significantly in size. The Financial sector is large and represents around 37% of the total value of the Australia 200 index. On the other hand the Information Technology sector  is much smaller, coming in at around 1%. This means Australian investors whose portfolios are broadly in line with the index, or who have passive share investments like index ETFs, are overweight financials and underweight IT in global terms.

The graph above shows the sector weightings for the Australia 200 index alongside major global indices. Note how financials and materials stocks comprise half of the value of the ASX 200. The only other index displayed with this large a sectoral skew is Hong Kong’s Hang Seng index. Comparing the Australian index to Germany’s DAX and the US S&P 500 and Nasdaq indices, there is an argument that it is severely underweight IT stocks, and underweight consumer related and healthcare stocks.

These sector skews are not necessarily a bad thing. Investors who want to overweight banks and miners may find an index investment alone is a good investment. However those holding substantial portfolio or fund index exposures not seeking this balance of sectors need to act.

What can investors do?

The central issue is the need to diversify across sectors. The best way to diversify depends very much on an individual investors existing holdings, so the right choice is specific to each situation. Nonetheless there are many suitable tools available to Australian investors.

Local choices

A simple response for those with existing portfolios is to re-weight across the sectors, going overweight under-represented sectors and underweight in financials and materials. The problem with this approach is the lack of enough suitable choices in the smaller sectors.

 Another possible approach is to invest a portion of capital in an actively managed fund. The style of the fund should diverge from the index. Suitable candidates include absolute return and value investor offerings. On a similar theme, ETF’s that offer sector, industry, commodity or geographic exposures could suit.

Direct investment in international share markets is an increasingly popular choice. Leveraged traders have dealt in CFDs over global giants such as Apple, Amazon, Barclays and Volkswagen for many years. Experienced investors who study the potential risks and benefits of these instruments also use them to shape the exposures of their portfolio.

Direct investment in international shares is also on the increase now that trading costs are more reasonable and service offerings are improving, admittedly from low levels. There are challenges here as well, particularly as Australian investors are used to registry or individual registration of shares, whereas many international markets operate with share custodians. Just like any other field of endeavour, investment markets reward hard work.