Why is it that some people achieve investment success, but others do not? Failing to find a winning strategy for your investment and pension portfolios can cost you many thousands of pounds, resulting in a lifestyle that is less than ideal.
The best way for investors to achieve the correct balance of risk and reward is to follow a process of asset allocation. Past studies have stated that properly managed asset allocation choices will be responsible for up to 87% of portfolio returns.
All too frequently, asset allocations are incorrectly established, meaning portfolios have too high a concentration of underperforming investments, or assets held out of proportion leading to specific investment specific risk.
In this short guide, I will show you how to organise your investments so that you can achieve the maximum benefit from asset allocation.
The process has nothing to do with investment costs, adviser fees or whether you follow an active or passive investing philosophy, and it most definitely has nothing to do with following investment recommendations in the media!
If you really want to improve the performance of your investment and pension funds, you need to have a clear understanding of the asset allocation process because it is the one core skill that investors should learn.
To fully benefit from dynamic asset allocation, you need to embrace the changes taking place in the world economy, and to respect, but step out of, the shackles of fixed asset allocation that is rooted in the past.
On average, 90 percent of the variability of returns and 100 percent of the absolute level of return is explained by asset allocation.” – Roger G. Ibbotson
Background to Asset Allocation
‘Operation Overlord’, more popularly known as D-Day, began on 6th June 1944, when some 156,000 American, British and Canadian forces landed on five beaches along a 50-mile stretch of the heavily fortified coast of France’s Normandy region.
The planning for D-Day was underpinned by research carried out by a select team of statisticians and mathematicians. Their task was to model all the variables involved in the landing and to pick the best beaches for the troops to fight on.
On D-Day alone, as many as 4,400 troops from the combined allied forces died. Some 9,000 more were wounded or missing. How many would have died without the meticulous planning that underpinned the D-Day landings?
After the war, the research that had been carried out in the planning for D-Day was applied to investing, which resulted in the 1952 white paper – “Portfolio Selection”.
Harry Markowitz and William Sharpe would later receive a Nobel Prize for the theoretical investment model they created, a major contribution to financial economic understanding and the basis of the Modern Portfolio Theory — an investment framework for the selection and construction of investment portfolios in order to obtain the best possible investment return combined with the minimum of investment risk.
Asset Allocation, simply put, is the process of combining different investments to obtain the best balance between risk and reward, then adjusted to match your investment personality.
The financial services industry in the U.K. began to improve standards within the industry and the practice of Asset Allocation first began to be implemented in the 1960’s.
A useful tool for investors to consider is an Asset Allocator grid:-
The Asset Allocation grid allows you to enter our chosen percentage asset allocation by asset class, then by completing the list of funds you hold, you need to calculate the split of an assets held by your funds (normally available from fund fact sheets).
If you can set up an excel sheet with the formulas that fit your circumstances, then you will be able to see from the columns’ totals whether or not you have too many or too few assets in any one column.
You will need to repeat this process every three months as your funds may have gone up or down in value.
You can correct any disparities, switching funds that fit your asset allocation model.
By ensuring you have the right spread of investments that are appropriate for you, you are reducing specific market risk by making sure you have proper diversification of asset class.
This allows you to keep tabs on your portfolio, and errors in asset allocation will either increase the risk of our investments or diminish the return.
If properly monitored the Asset Allocator grid works as an investment “auto-pilot” allowing you to maintain investment balance.
The following two portfolio charts are simply the last two portfolios we reviewed and, despite being ‘managed’ by professionals, both asset allocation and choice of funds are poor, resulting in under performance.
Asset Allocation and Diversification are inexorably linked.
A fair description of asset allocation is intelligent diversification of assets.
The Modern Portfolio Theory (MPT) was devised at a time when most investors invested directly into equities and bonds, it provided a framework in which more cautious or balanced investors could include a proportion of higher risk investments within a carefully constructed portfolio.
The MPT is not without its critics, the most contentious point being that it linked volatility and investment risk.
Unfortunately, a large proportion of the financial service industry seem to have taken this to heart.
The emphasis should be on the main aspect of the MPT, that is combining a variety of assets with differing capital variances, given that most investors these days are mainly invested in collective investments, rather than involvement with direct investment in equities when the MPT was formulated, investment risk can be overstated.
Investment oriented advisers often believe that they have excellent fund picking skills, and will point to their outstanding fund selections, but if their portfolios are shackled by fixed asset allocation, any overall performance will be constrained.
Other advisers tend to stuff a portfolio with what is perceived to be a collection of low risk funds, with similar characteristics meaning there is little real diversification, the antithesis of the MPT.
William (The Sharpe Ratio) Sharpe who was one of the planners involved in the D-Day preparations and a joint contributor to Portfolio Selection believed that diversification was possible with as few as eight funds.
In graph A the Financial Planning firm has over diversified their portfolio, so the small number of growth funds they have selected will make little or no difference to overall performance, the diversification score does not even register, you are probably better off buying premium bonds.
The result, at best, mediocre or persist poor performance.
Wide diversification is only required when investors do not understand what they are doing.” – Warren Buffett
It is only by carefully combining assets that have a variety of capital variances that will fulfill the MPT and provide a better combination of risk and reward.
The second chart illustrated is from a very large well-known insurance and pension company, who are acting as discretionary fund managers to the portfolio.
There are 32 different funds in the portfolio, including several of their in-house funds.
If you are a discretionary fund manager and include your own funds in our portfolios, you are required to make a case for their inclusion, so a large investment in the portfolio of one of their in house funds that has produced a performance of 1% over three years – is surely indefensible, particularly as it takes up 22% of the overall portfolio.
The remaining fund choices are not the best of class, so it is not surprising that the portfolio is underperforming.
The disparity between their fund selections and how the portfolio should have been allocated, is highlighted by inputting their choices into an asset allocation grid, clearly the investment fund managers have completely lost the plot, as we discovered that 30% of the portfolio was mis-allocated.
When you combine poor asset allocation and poor performance, you can imagine the result, the client had made virtually no money in five years.
Nor is this an isolated incident.
One of our clients has their work pension with this same company, and they are running the massive pension fund as ineptly as they have mis-managed our other client’s portfolio.
The diversification rating of 17% for the portfolio is damning.
How do they get away with it?
The poor performance demonstrated by these two examples demonstrates why it is so important to follow a robust asset allocation process.
There are three main types of Asset Allocation Strategy:
- Investment Timing
- Fixed Asset Allocation
- Strategic & Tactical Asset Allocation
This is the practice that involves taking a view of the stock market and either investing 100% of your monies in the market or exiting the market completely and switching all our investments into government bonds. This should be left to the hedge funds, or investing geniuses like Warren Buffet, or the late Sir James Goldsmith, who cashed out of stock markets just a few weeks before the 1974 stock market collapse.
Fixed Asset Allocation
This dictates that you invest proportionally in a range of different asset classes and government bonds, depending on your investment personality. It is a discipline that requires no knowledge of world economic and financial events. The fixed percentages are maintained by regular quarterly rebalancing of portfolios.
Whenever there is an increase in stock market volatility, investors advised not to panic and that, over time, stock markets will recover, and everything will be ‘back to normal’.
Advice that has served investors well in the past but may not serve them well in the future.
Fixed Asset Allocation models for balanced investors essentially work on a 35% bonds 65% collective equity split. Equity holdings are viewed as the risk element of the portfolio and government bonds are viewed as the safe haven counterbalance for the portfolios.
Pension funds also use government bonds as the safe haven in the mix of their pension funds, in addition they invariably advise clients to ‘lifestyle’ their pension portfolios, meaning that they increase the proportion of government bonds in their pensions as they approach retirement.
Global investors also like to rest their monies in bonds when the stock market gets over heated, as historically they have been able to get a 3% yield.
Equities and bonds, the Yin and Yang of investment markets have over the years been negatively correlated but no longer, Modern Monetary theory has destroyed the inverse relationship.
Bond investors get little or no yield and are unlikely to be returned the same monetary value when they exit.
The massive injections of liquidity and anticipated future inflation are fuelling the demand for precious metals, one of the reasons why, over a year ago, we recommended that investors should consider investing in gold collectives.
As for the belief that this is a temporary financial crisis, it is not, the world has fundamentally changed forever. The lurch to technology and technological solutions will have a profound and wide-ranging effect, including reducing the number of jobs available and on social stability.
The cataclysmic changes in the world economic and financial order are either not understood or are being ignored. The lack of engagement and understanding of economic events and reliance on a buy and hold system that suited conditions seventy years ago has duped many people into believing that the financial crisis will be short lived and that investments markets will carry on as before.
Almost all economies are engaged with policies of ‘financial repression’, expanding their economic activity by borrowing or printing more money, holding interest rates down, as they can’t afford to service the debts they have created if interest rates did go up, and gambling that inflation will rise – easing their debt burden.
Government bonds around the world (except for China), are now yielding almost zero or negative interest rates. With further money supply expansion planned, government bonds are no longer a safe haven: indeed, they are the epicentre of financial risk.
Yet many fixed asset allocation models are still advocating a high percentage of government bonds in their investment mix, why, well this is the way they have always arranged asset allocation.
The lack of necessity to maintain other than a fleeting interest in world events, blinding them to the financial consequences of following a rigid methodology in the face of rapidly changing financial and economic events.
Alternative hedges against equities should be considered, these include a small number of corporate bond funds, absolute return funds, hedge funds and precious metals.
Surely it is preferable engage with world events and understand the momentous changes that are taking place and reallocate portfolios accordingly.
Failure to understand or ignore the change taking place, means not only that your investments will lose money but also that you will fail to spot the many opportunities that spring from change.
That is why, after much deliberation eighteen months ago, we fundamentally changed our approach to investment and now use strategic and tactical asset allocation.
A comparison of three of our balanced portfolios with the two discretionary managed portfolios discussed earlier.
The difference between success and failure is not which stock you buy or which piece of real estate you buy, it’s asset allocation” – Tony Robbins
Tactical Asset Allocation
The study of the movement of short- and long-term averages of stock market indices has been practiced for many years. The resulting buy and sell signals are published as the “Coppock indicators”.
The Coppock indicators have been primarily used to spot when bull markets are commencing, rather than study the investment markets solely for the buy and sell triggers alone, a daily look at a variety of stock market indices provides a very good indicator of the investment trends of the stock market, providing pointers both for opportunity and risk.
If there is perceived to be a heightened level of risk in any one asset class. then it makes sense to reduce exposure to that asset class or sector. Timely action can reduce investment loss.
Likewise, increasing allocations to asset classes that are trending higher will improve portfolio returns over time.
The trend is your friend (as chartists will tell you), until it isn’t, so you need to be able to interpret stock market indices price movements and work out when a trend is ending. Fortunately, we receive regular guidance in this regard.
Unlike fixed asset allocation there is no automatic quarterly rebalancing, the trend of the investment indices is held until there are signs that the trend is ending, so the timing of portfolio rebalances is when market conditions dictate.
There is no such thing as a sure-fire way to investment success, it makes sense surely to embrace change and seek profitable opportunities than to take no action whatsoever, so you will need to pursue some form of strategy.
Strategy matters because differences in return can be significant, especially over time. If you follow this guide and our previous guide “The importance of Investment Performance”, you have all you need to take control of your investments.
Asset Allocation is a critical tool because it allows you to influence the investment process, and control and influence future returns.
You should consider an asset allocation strategy that is open to engagement with the economic and financial changes taking place in the world, not an asset allocation strategy that is ignoring the fundamental shifts of economic activity and trends taking place.