By Daniel Archibald | CFA
Asset allocation has often been shown to be the prime determinant of overall portfolio performance. Or, in other words, deciding how much exposure your portfolio should have to shares or cash, is a more important portfolio decision than whether you should own Telstra shares or Woolworth shares. This is not only due to the high correlation between similar assets, but also the large differences of long-term return and risks between the different asset classes.
What are Asset Classes?
The main asset classes are cash, bonds, equities, property and other. This last class, also known as "alternatives" includes everything that isn't the first 4 (hence the name), including real assets (infrastructure, commodities) and investment strategies (hedge funds). Most investors in Australia will split equities between Australian and International, but you could specify more or less than these generic sectors. The main key to defining your asset classes is to try and lump investments with the similar risk and return characteristics into the same class.
How Do I Allocate Between Asset Classes?
Performance indicators show that, in the long-run, equities should outperform property, which should outperform bonds, which should outperform cash. So wouldn't it be wise to just invest in shares? Not necessarily.
There are a few reasons why diversifying your portfolio between a number of asset classes is important. Firstly, you may not be investing for the "long-term" and in the short-term shares often underperform other asset classes (or suffer significant losses). Also, investing in volatile assets may pay-off in the future, but many cannot cope with the ups and downs of markets and their portfolios. Thus, overall, it is important to understand your personal investment goals and objectives, and also your ability and willingness to accept investment risk.
Once you understand these factors, it can than be possible to determine what kind of allocations might be appropriate in your personal circumstances.
How Do Manage My Asset Allocation Over Time?
Due to asset price movements, if you do not do anything, your portfolio is likely to drift away from the original exposures. There are 3 main ways of administering your overall asset allocation strategy, which look to address this issue of exposure "drift":
- Set and Forget - aka "buy and hold" - this asset allocation strategy involves setting your asset allocation when you establish your portfolio and then investing in the appropriate securities so that your initial portfolio is in line with this allocation. After this initial work, no changes are made, thus you allow your exposures to "drift" over time. Assuming shares and property outperform cash and bonds over a period of time, your portfolio is likely to become more exposed to the former. This approach can result in higher returns over time, due to higher exposures to potentially higher performing sectors, and also lower transaction costs (as you don't make any transactions).
- Rebalancing - aka "dynamic" - this strategy involves periodically adjusting your portfolio so that your asset allocation is brought back into line with the initial exposures. Again, assuming shares and property outperform in a given period, such an investor would likely reduce these asset classes and buy those with lower returns. This approach is likely to lead to a lower amount of risk in your portfolio (or at least maintain your overall risk profile), and can also produce superior returns in markets that show signs of mean reversion.
- Tactical - aka "active" - this asset allocation strategy involves simply placing more of your portfolio into asset classes that are expected to outperform over the short to medium term. Generally speaking, investors who follow this type of approach will look to set a benchmark/long-term asset allocation and then make active calls away from this when opportunities or threats arise. For example, the long-term exposure set for an investor may be to have 50% in equities, but due to increasing concerns over economic stability, they might decide for the next 3-6 months to only have 30% exposed to the share markets. This type of approach can also incorporate the above "rebalancing" strategy and can lead to lower volatility and higher overall performance, though greater resources and research are likely required.
Regardless of how much investment risk you wish to take on, or what kind of asset allocation strategy you think would be best for your circumstances, it is important to understand how much asset allocation management can affect your overall portfolio performance. This should be the first and most important question to be answered when considering how to invest your hard earned savings and achieve your investment goals and objectives.