The importance of asset allocation
Getting your asset allocation right is difficult, it requires patience, risk management skills and conviction to go against the wisdom of the crowd. This is why many investors have a share dealing account, where they invest in their best ideas, and a managed portfolio where they leave their long-term investment allocations in the hands of investment professionals.
Many investors we meet are passionate about investing, they know a lot about individual stocks, follow respected market commentators and keep abreast of the latest economic news. However when we discuss terms such as correlation, standard deviation, and Sharpe ratios, their body language begins to change and the conversation shortly moves on to something else.
It’s not surprising that many people find maths and statistics boring, but the unfortunate thing is that these concepts are the building blocks behind how the core of a portfolio – the asset allocation - is determined.
Asset allocation is important, not because it is a wealth creation tool, but because it is critical in determining the amount of risk that a client portfolio will take on over time. A successful asset allocation should aim to deliver your portfolio superior risk-adjusted returns – giving you the highest return for the lowest amount of risk – while managing downside risk and implementation costs. If you were to stop monitoring your investments, your asset allocation should be robust enough to let you sleep well in the knowledge that your investments are on the right track.
Which asset class will perform best in 2017?
The image below shows the GBP returns for a range of asset classes. It’s evident from the random nature of the blocks that what works well one year, has little predictive power on what will perform well next year. Nevertheless, you can still get an idea of which asset classes are most risky. For example cash and bonds have a lower volatility than equities, listed property and commodities.
An effective asset allocation is not about picking the winners every year, but about building a portfolio with a blend of assets that will perform in a steady manner over time. Overcoming behavioural biases, buying at the top, selling in despair at the bottom, and running losers too long is part of the challenge.
Building a robust portfolio requires knowledge and skill
Asset allocation is complicated, it requires technical knowledge – understanding the relationships between asset classes, long-term discipline (not selling when markets fall) and constant research and analysis to unearth rewarding investment opportunities.
A multi-asset portfolio brings together combinations of different asset classes, with the aim of delivering a portfolio that satisfies a client’s risk and return requirements. Portfolios are monitored on an ongoing basis, to assess whether the current asset allocation is suitable for market conditions. In short, portfolio manager’s job is to make sure that at any point in time, the portfolios are set up to achieve the returns that clients need to achieve their goals.
Source: Bloomberg. Using weekly returns from 03/2007-03/2017. Equities are represented by MSCI World GBP, Bonds using the Barclays UK Government All Bonds, Cash is 3-month LIBOR, property is FTSE EPRA NAREIT Total Return GBP, and Commodities are the Bloomberg Commodity Index Total Return GBP.
Diversification – tried and tested over time
The most dangerous thing your asset allocation can do is to have all your exposures reliant on a particular scenario happening. For example, over the past five years, investors that believed in Peak Oil theory saw a glut of alternative energy sources flood the market leading to the price of oil plummeting from over $100 a barrel to less than $30 two years later. Putting all your eggs in one basket can cause long term investment harm.
Diversifying your investment portfolio means allocating to investments that behave in different ways. When one asset class goes down in price, others may go up, and some may not move at all. This helps smooth returns, and gives flexibility to invest in poorly performing asset classes when they are cheap while reducing exposure to those more expensive parts of the market.
Asset class correlations enable an asset manager to add assets - that by themselves are high risk, or out of fashion - to a portfolio in order to lower its risk. For example, a portfolio made up of 100% fixed income could have risk lowered by adding some equity exposure. This is because when fixed income performs poorly (such as in rising interest rate environment), equities may perform well as rate rises usually occur in a strengthening economy.