Asset allocation is seen by many as the main driver behind investment performance. So what is it and how does it work?
Asset Allocation aims to maximise your investment return for any given level of risk, or reduce the risk for any given level of return, by allocating your capital to different types of asset in appropriate proportions. It is based on evidence that each asset class behaves differently with very different risk profiles. In essence, it is a more sophisticated version of the old saying ‘Don’t put all your eggs in one basket’.
There are four major asset classes: cash, fixed interest, equities and property. Other asset classes are either sub-sets of the four main classes or alternative assets, such as commodities.
The benefit of spreading your money is because historically different assets behave differently. This is called correlation. Over the long term, evidence shows that cash has a very low correlation with equities and property; that property has a higher correlation with equities; and that, in normal times, equities have low correlation with fixed interest. However, correlations between sub-classes, such as between emerging markets and developed markets or government bonds and junk bonds, are much less reliable, with major variations over different timescales.
So how do you make asset allocation work for you? The starting point is to determine your financial goals. You must then assess how much risk you are willing and able to take to help achieve them. Your attitude to risk, your age and your investment timescales will all impact upon your asset allocation decisions.
When it comes to asset allocation, there are two common approaches: strategic and tactical. Deciding which strategy or mix of approaches is down to you, ideally assisted by an independent financial adviser.
Strategic asset allocation is based on defining and fixing portfolio assets allocations from the outset, based on historical performance data. Fund managers using this approach do not usually exploit short-term opportunities. Rather, they rely on historical data to indicate long-term performance for the respective asset classes, using significant resources to review and analyse the data.
Tactical asset allocation also adopts the fixed asset weightings of a strategic portfolio. However, it also gives investment managers the flexibility to vary those weightings in a risk-controlled framework, taking advantage of short-term market inefficiencies, whilst managing investors’ exposure to risk. They normally do this by evaluating the relative attractiveness of Cash, Bonds, Property and Equity markets through financial valuation, growth and sentiment measures. They then assess the current attractiveness of those classes and alter portfolio weightings accordingly.
Both sides have their advocates, so which approach is best for you? Strategic asset allocation is probably right if you like to keep things simple and don’t feel comfortable with the extra costs of tactical asset allocation and no guarantee of outperformance. Tactical asset allocation may appeal if you want to take more of an interest in your portfolio and because you know that during times of market turbulence, your fund manager is trying to reduce risk and increase returns for you.
To discuss asset allocation in more detail and how it can help your investment portfolio, contact Kellands.