It's believed at least 80% of your portfolio returns can be attributed to asset allocation – so choosing what proportion of wealth is invested into each asset class is a crucial decision. What must you consider while making these choices?
Typically a portfolio is split between equities, bonds and cash, but may also include exposure to other asset classes including real estate, hedge funds, private equity and commodities.
The dominance of the asset allocation decision relative to individual stock selection is based on the fact that different asset classes are not perfectly correlated i.e. their performance does not move up or down by the same amount at the same time.
Consequently, a portfolio benefits from investing across different asset classes – and through diversification within asset classes, an investor can optimise the portfolio’s risk-adjusted returns.
Active management within an asset class may yield positive relative returns i.e. it can lead to the outperformance of the respective benchmark index, either because the single assets selected performed better than the overall index or because the market timing decisions were beneficial.
Know the worth of asset allocation
Finding a suitable asset allocation is vital because this determines a significant proportion of the portfolio’s overall return. Investors should construct a portfolio that is diversified both across and within asset classes.
Having clearly defined your target return and your willingness and ability to tolerate risk, what now? Where should you invest your money?
While the exact figure is debatable and depends on your point of view, it is widely believed that at least 80% of your portfolio returns can be attributed to the portfolio’s asset allocation and hence determining what proportion of your wealth is invested into each asset class is crucial.
When considering your asset allocation, the well-known saying ‘don’t put all your eggs in one basket’ definitely applies.
Diversified wealth is protected wealth
The chart below illustrates the performance of three different strategic asset allocations with differing risk levels: income (least risky), balanced, and growth (most risky). Here we can see that over a long period of time, a higher risk portfolio generally achieves a higher overall return but at the price of greater fluctuations in value.
What do you need to consider when deciding on the asset split in your portfolio? Firstly, you need to make sure that the investments in the portfolio have the potential to yield the return that you are targeting.
Secondly, in terms of risk, it is important to understand the concept of diversification and then ensure that the overall portfolio risk level is appropriate.
A practical strategy
If a portfolio was made up of one single asset or different assets which always moved up and down at the same time, there would be a greater risk that investments across the entire portfolio would lose money at the same time resulting in a decrease in wealth.
In an extreme case, say for example an investor’s entire wealth was invested in the equity of one firm, and a negative news event broke in relation to this firm – resulting in a 20% fall in the share price. The investor’s portfolio would lose 20% of its value.
However, if this one stock represented just 1% of a well-diversified portfolio, the impact on the overall portfolio of this 20% share price decline would be just –0.2%.
In this situation, an investor would hope that the return on the other investments in the portfolio would offset or ideally outweigh this negative return, thus ensuring a positive investment return overall. This example illustrates that when considering your asset allocation, the well-known saying ‘don’t put all your eggs in one basket’ definitely applies.
Sharing the burden of fallen equity
Diversification is important both in terms of the asset class split as well as within asset classes i.e. a portfolio should be invested in more than one asset class (e.g. equities, bonds, cash), and in the same way, the equity portion should be diversified through exposure to different regions, sectors and investment styles and not concentrated on the equities of just a few companies. Likewise, the bond portion of the portfolio should be diversified across various segments, durations etc.
Through diversification, an investor can reduce the risk taken and the overall portfolio return is likely to be less volatile.
No matter how much research has been done, the one certainty in life is the existence of uncertainty and consequently there will be risks inherent in any investment, albeit more in some than others. If an investor were to split his eggs between many different baskets, losing one basket completely (e.g. if the value of one particular equity were to fall to zero) would have a relatively small impact.
In terms of investing, this translates into allocating portions of your portfolio to different asset classes. Historically, different asset classes have not been perfectly correlated. Through diversification, an investor can reduce the risk taken and the overall portfolio return is likely to be less volatile.
To risk or not to risk?
With all this talk of lowering risk, it is important to remember that a portfolio would also suffer from not taking enough risk. Building an efficient portfolio (minimising the risk for a given expected return) is very important, but so is investing in sufficient risky assets – because if the time horizon is long enough, then taking risks should pay off.
The chart below shows the impact on the performance of the ‘Strategic Asset Allocation Balanced’ of holding a higher allocation to cash. This clearly illustrates that as the allocation to cash increases, the overall portfolio return decreases.
While equities exhibit higher volatility, they also generally achieve higher returns – while the opposite is true for cash. If the period of time is long, the chance that an investor loses money with equities is lessened.
Furthermore, the ageing population increases longevity risk (the risk that people live longer than expected) and hence the risk that people’s savings are inadequate and run out before the end of their lifetime.
Asset allocation for the future
To bridge this gap between people’s means and needs, personal savings and investments are set to become an even more important portion of retirement incomes, relative to any form of government pension.
Thus in the current environment, with life expectancy rising while bonds are yielding very little and interest rates are at very low levels or even negative, it is more essential than ever that investors make an appropriate allocation to risk assets.
How to invest
Financial subjects can be complex in nature. Our ‘How to Invest’ series aims at explaining them – one step at a time.