Asset Allocation

There are different fundamental strategies available to investors both active and passive however it is universally accepted in the investment community that asset allocation is the single most important contributor to investment returns. The latter does not principally come from choosing the best stocks or fund managers. Estimates I have seen is getting the right asset choices accounts for 90% of returns. An example can be seen from 2008. The banking crisis in the autumn led to a savage sell off in equity markets whilst property and corporate bonds also fell. The best performing assets were safe haven government bonds including UK gilts and US treasuries. The point here is with hindsight in 2008 it would have been best to have held government bonds and avoided equities. Holding the best stocks or fund managers was largely irrelevant in equity markets that were selling off sharply and indiscriminately. You might have lost 20% that year rather than 30% – better than the average equity investment perhaps but cold comfort none the less.
 
In March 2009 equity markets rallied sharply and shares were the best performing assets. Those who bought into markets in late 2008 and early 2009 made a killing, although many investors having recently had their fingers burnt were too cautious to put cash into the markets when sentiment was so bad.
 
Similar analysis of historical asset performance from Scottish Widows show that commodities were the best performing assets in 2005 whilst data from Jupiter shows that European equities outperformed UK, US, Far East and Japanese equities in both 2003 and 2004. In recent years of course the tide turned for both assets –  European equities have fared badly with the EuroZone crisis whilst commodities sold off sharply in 2011 and early 2012. This demonstrates that asset performance is volatile and dynamic. Further valuations may reach bubble territory and turn traditionally low risk investments into high risk assets – for example UK gilts look very expensive and vulnerable to a fall in prices.
 
The problem with this analysis on asset performance is that it is observable with hindsight. Few people have the foresight to make a right tactical asset call in advance and those that do rarely commit all their investment monies to a single asset class as it would eliminate diversity from a portfolio and be extremely high risk if the assessment was wrong. Moreover it is not just about picking the right asset but getting the timing correct. All the evidence suggests timing the market is notoriously difficult. It is for these reasons that most investors have a spread of assets and many adopt a long term buy and hold strategy. This is advocated by a number of fund managers who stress the importance of “time in the market” not “timing the market” and offer evidence from historical data that the latter is costly if you miss a relatively small number of days where markets perform strongly. This is a fair point but I am not convinced a totally passive approach delivers the best results. Whilst most of us do not have the time to actively trade on a short term basis I think it is possible to overlay some tactical investment strategies over a core long term strategic asset allocation. 
 
So building a new portfolio from a cash today I would suggest a two strand approach a strategic long term asset allocation of some monies – currently I favour equities, commodities and high yield bonds over safe government bonds (index linked excepted) and property. Within equities I favour emerging markets, global equity income and smaller companies. In addition I would retain a sum of money in cash as an emergency fund and in part for tactical asset allocation to equities if markets crash.
 
In conclusion the greatest priority with your investment planning should focus on your asset allocation. It will need to be dynamic and active – monitoring and reviewing, taking profits, rotation in and out asset classes or adjusting the balance of a portfolio. In addition the right asset allocation for an individual investor naturally depends on a number of other factors – the size of a portfolio, the timescales for investment, attitude to risk and the purpose of investment. All of this is has to be assessed in the wider context of the global economy, current market conditions and the risk/reward dynamics of different assets. As usual individual independent advice should be sought.
 
Finally you may have come across model portfolios with set asset allocations. These are funds with allocations to different asset classes that depend on risk assessment or investment objectives. Space does not permit comment here except I don’t like them and don’t use them. They are off the shelf “Centralised Investment Proposals” (CIPs) which are matched to suitable investors. Personally I prefer individual tailored solutions whilst recently the Financial Services Authority have expressed concerns about IFAs “shoehorning” clients into CIPs. More on this subject in a future blog post.