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by Brian Bloch
That old adage "everything in moderation", is at the core of the investment process. A major American study demonstrated recently, that as much as 90% of the returns from a portfolio depend on one single factor: an optimal and prudent balance between the basic investment categories of shares, bonds and cash.
There is probably nothing more fundamental than dividing the "investment pie" appropriately between the so-called "asset classes". Apart from the three classics of equities, bonds and cash, some investment in property funds and the controversial hedge funds also provides real diversification.
Given the critical nature of asset allocation, it is surprising how many people get it wrong and often very wrong. This applies not just to individuals, but to investment firms and advisors as well.
Therefore, private investors should ensure that they themselves know what kind of risk they are taking on, and whether the extra potential returns from riskier investments are really worth it to them. Often, the higher risks are not worth taking.
So what exactly goes wrong? One expert stressed recently that the biggest mistakes are "too many shares and too many UK shares". Britain and many other countries are full of the victims of just such errors.
Especially in boom times, firms and private investors alike are tempted by the high returns from equities. And British people tend to go with what they know, or think they know. Hence the second error - having too many UK shares.
It may seem obvious that the risk-return trade-off would form the basis of any portfolio. Yet clients of many investment houses are currently complaining that risk was neglected and that firms worried more about their own earnings than those of clients.
Insiders have revealed that investment companies frequently make more commission from selling shares than from bonds and other safer assets. Therefore, shares are what they sell. An extra one or two per cent commission, can do amazing things to fund managers' perceptions of what their customers should buy. This applies to some IFA's as well.
Companies which (until 2000!), sold virtually all-equity portfolios, were not only doing clients a major disservice, many were misrepresenting the level of risk quite substantially.
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Above are the suggested basic asset allocations from the firm Sanco Services. These demonstrate clearly the way in which the proportion of equities in a portfolio is increased for more risk-friendly or aggressive investors. There would also be some cash in addition to the equities and fixed-interest assets. |
Yet statistical evidence proves that the misery of massive losses in stock market slumps can be minimised by keeping to a few simple rules. While there is no complete consensus as to whether, for instance, a medium risk "profile" contains a maximum of 50% or 60% equities, the range given by countless objective experts is close enough to draw clear boundaries.
If these "rules of risk" were adhered to consistently, irrespective of the state of the market and economy, there would presently be fewer people lying awake at two in the morning staring at the ceiling.
The lessons of history… and experienced stockbrokers tell us that the proportion of a portfolio invested in shares is at the heart and soul of asset allocation. No matter how many different kinds you have, "shares are shares" and, no matter what the mix, they offer no real risk-reducing diversification. This comes only from non-equity assets such as bonds.
Standard international industry practice often works in terms of three simple categories - high, medium and low risk. The main danger is having a high risk portfolio when one really ought to have low or medium risk. Yet it is not difficult to figure out what is right for a particular person.
There are numerous books, magazines, internet sites (e.g. www.sancoservices.com) and investment-company pie charts with "risk profiles", which demonstrate, based on decades of experience, how to avoid disastrous losses that one simply cannot afford.
For instance, someone in his 30's, who does not own his own property (but would like to) and is not in a particularly stable job, is a prime candidate for low risk. This means no more than 25-30% shares, even in the present, relatively cheap market.
Risk-friendly investors can push their luck and raise the percentage. However, they should be aware that they are entering the realms of gambling and breaking the generally accepted rules of asset allocation.
On the other hand, consider someone who is 50 years old, owns his own mortgage-free home, has a safe, well-paid job, a pension fund and has just inherited £300 000. This sum can be regarded as spare money for higher-risk/higher-return investment. Depending on personal preference, it may not be imprudent to put 80% of the inheritance into shares.
However, the investor might still be happier with medium risk where the danger of capital destruction, especially in the short to medium term, is far lower. Research shows that most people are more miserable with losses than they are thrilled about gains.
The classic question, far too seldom asked is: "how would you feel if you lost 10, 20 or 30% of your capital…. or more?". With higher-risk portfolios, this can really happen, as is all too evident right now.
There are other asset allocation issues which impact massively on both risk and return. More geographical diversification between the UK, Eastern Europe (performing extremely well at the moment), Asia etc. must not be underestimated as a means of altering the levels of risk and return.
Similarly, the non-equity part of the portfolio can vary from a wide range of "old-fashioned" bonds, to a relatively low-risk hedge fund (a "fund of funds"). And bonds too, may be local or foreign.
In summary, these asset allocation decisions form the basis of any portfolio. Consequently, they are more important than the actual stock selection and timing decisions. If the basic mix is right, you cannot go all that far wrong.