So What’s Asset Allocation & What’s The Point?

I have mentioned throughout many articles, as financial adviser, professional investor and wealth manager, the importance of asset allocation.

I think it is worth explaining more, as to what this means to me.

Many financial experts believe asset allocation is an important factor in determining returns for an investment portfolio. Asset allocation is based on the principle that different assets perform differently in different market and economic conditions. So, diversification reduces the overall risk in terms of the variability of returns. Academic research has painstakingly explained the importance of asset allocation and the problems of active management.

Asset allocation is an investment strategy that attempts to balance risk versus reward by adjusting the percentage of each asset class in an investment portfolio according to the investor’s risk tolerance, market expectations, client’s goals and investment time frame.

Each asset class will move to some extent either correlated or negatively correlated with equities. So what this means is some assets will rise and fall with equities; and some assets will generally fall when the stock market rises and vice versa. By combining these assets in a portfolio, we can diversify what we hold and the volatility of the portfolio. The dream is to achieve a straight line of growth no matter market conditions. Admittedly, I believe that this is impossible but it’s what we strive to achieve.

The more equity exposure we take, where the risk profile is increased the wider the range of the possible outcomes both positive and negative. My underlying strategy is to take a diversified broad-based approach but when markets correct aggressively, then the risk-return ratio can achieve significant returns, at least in the short-term i.e. buy cheap and sell at a higher price. Over time the market typically returns to an average return, so care needs to be taken when considering if we are above or below the average. The question being; Are pressures in the market up or down? What time scale are we considering? Following the banking/debt/global economic crisis, what is our time horizon? And, what should it be?

I believe a key constituent to developing a strategy is market expectations. Personally, I am not willing to place a client in an asset allocation, where I expect we will make a loss. I see a person’s risk tolerance as their maximum or normal exposure in a rather abnormal world.

Any decision around this area is discussed first with my client. (My crystal ball works no better than anyone else.) If we are expecting a market pull-back (decline) then a more defensive strategy than normal may be more suitable. By asset allocating, then if we expect equities to drop in value, other markets are growing and so combining or excluding some assets can obtain positive returns in declining equity markets.

Asset classes and strategies

There are many types of assets that may or may not be included in an asset allocation strategy:

• cash and cash equivalents (e.g., certificate of deposits, money market funds)
• fixed interest securities such as Bonds: investment-grade or junk (high-yield); government or corporate; short-term, intermediate, long-term; domestic, foreign, emerging markets; or Convertible Securities
• stocks: value, dividend, growth, sector specific or preferred (or a “blend” of any two or more of the preceding); large-cap versus mid-cap, small-cap or micro-cap; public equities vs. private equities, domestic, foreign (developed), emerging or frontier markets
• commercial property or residential real estate; and REITs
• natural resources: agriculture, forestry and livestock; energy or oil and gas distribution; carbon or water
• precious metals
• industrial metals and infrastructure
• collectibles such as art, coins, or stamps
• private equity and Venture Capital
• and others

There are several types of asset allocation strategies based on investment goals, risk tolerance, time frames and diversification: strategic, tactical, and core-satellite.

Strategic Asset Allocation — the primary goal is to create an asset mix that will provide the optimal balance between expected risk and return for a long-term investment horizon.

Tactical Asset Allocation — a more active approach that tries to position a portfolio into those assets, sectors, or individual stocks that show the most potential for gains.

Core-Satellite Asset Allocation — a hybrid of both the strategic and tactical allocations mentioned above.

Systematic Asset Allocation – depends on three assumptions:-

• Markets provide explicit information about the available returns.
• Relative expected returns reflect consensus.
• Expected returns provide clues to actual returns.

Return versus risk trade-off

In asset allocation planning, the decision on the amount of stocks versus bonds in one’s portfolio is a very important decision. Simply buying stocks without regard of a possible bear market can result in panic selling later. One’s true risk tolerance can be hard to gauge until having experienced a real bear market with money invested in the market. Finding the proper balance is key.

Asset allocation is important. It determines an investor’s future return, as well as the bear market burden that he or she will have to carry successfully to realize the returns. We are looking to an investor’s sensitivity to loss in the hope of long-term profits.

It is interesting to see that those with a more cautious prudent approach over the medium to longer term have performed better than more speculative strategies. The depth and severity of the recent recessions (or bear markets) have been the primary contributing factor.

My experience is that my clients risk profile is affected by the level of fear of losses. Generally speaking, I believe we should take a more prudent approach unless the market creates an opportunity to make enhanced profits.

Problems with asset allocation

There are various reasons why asset allocation fails to work.

• Investors’ risk tolerance is not knowable ahead of time.
• Security selection within asset classes will not necessarily produce a risk profile equal to the asset class.
• The long-run behaviour of asset classes does not guarantee their shorter-term behaviour.
• Most all asset allocation decisions fail to consider the effects of personal circumstances and any life changing events

Any questions email me – welshmoneywiz@virginmedia.com

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