Asset allocation - as important as ever

This is the time of year when many investors return to the financial markets, reassess their goals and reorganise their portfolios accordingly.
Recent stock market volatility has reminded investors that achieving the first goal is by no means straightforward. While share prices were soaring, it was easy to adopt an aggressive approach to asset allocation.

But sharp falls in market indices in the second quarter of the year have demonstrated the dangers of being caught on the break.

Getting the right balance of risk and reward is particularly important for many people entering retirement who may need to make their savings last for several decades.

No investment strategy works for all of the time. Investment markets move from being too cheap to too dear. At this point, you must change your asset allocation strategy.

Research has demonstrated that asset allocation accounts for approximately 90 per cent of the variation in investment returns.
This means that asset allocation alone is nearly 10 times as important as stock selection and market timing combined in determining the performance of a portfolio.

A good example of this was reported at the beginning of 2006 concerning commercial property. The Duke of Westminster, Britain's biggest private landlord, warned that the commercial property market had moved towards unsustainable territory.

Quite separately, the FT reported that commercial property auctions were standing room only with twice as many eager buyers as existed in 1991 when prices were at rock bottom.

In 1991, the commercial property market was unquestionably cheap, and today it can be regarded as being far too dear. It is clear that property is not as good a long-term investment opportunity as it was. Just because returns have been good for a few years, doesn't mean that they will continue.

A big difference between property and other asset classes is that with property often a great percentage of the purchase price is borrowed money.
How can the optimum asset mix be achieved?

Asset allocation is the diversification of a portfolio across different asset classes and geographical regions with the aim of maximising investment returns whilst reducing the portfolio's overall volatility, or risk, to below that of its individual components.

This is achieved by mixing assets which are ideally negatively, or at least weakly, correlated - that is, unlikely to move in the same direction to the same extent under the same market conditions.

This is the key principle of ‘modern portfolio theory’, that risk reduces as the assets held by a portfolio become more diversified.

However, the art of asset allocation goes beyond mere diversification. It looks to allocate the optimum proportion of a portfolio to each asset and geographical region.

As the investment environment is constantly changing, it is vital that any portfolio's asset allocation is regularly rebalanced to take account of prevailing market conditions, as well as any changes to the investor's objectives, attitude to investment risk and timeframe for investment.
Current conditions would allow balanced investors to hold up to 85 per cent of their portfolio in equities with the aim of increasing the real value over the medium-to-long-term.

The remainder is normally invested in cash or fixed interest securities, whose long-term returns have historically been lower than equities but also generally less volatile, and/or property.

Marc Gordon, managing director of Close Fund Management, said: "Investors will always want the best of both worlds: capitalising on the market's good times and sheltering from the bad, that is, earning good returns and not taking on significant risks.

"Yet there are very few products that meet those criteria. While regular deposit savings accounts offer capital protection, albeit not from inflation, returns are generally low, and investors do not benefit from the returns that stock market investing can offer."

With-profits

Insurance company with-profits funds invest in a mix of equities, fixed interest securities and property with the aim of smoothing out the peaks and troughs associated with these asset classes individually.

Most with-profits funds now hold a higher than ideal proportion of their assets in fixed interest securities, property and cash, which has rendered the asset mix underlying them appropriate only for very cautious investors.

Managed funds

The advantage of using managed funds to achieve the model asset mix is that, like with-profits, the need for ongoing monitoring is reduced as each manager adjusts the fund's overlying asset allocation as well as the underlying investments on a daily basis.

On the downside, managed funds are invested with the average investor in mind, with attempts to meet the optimum asset mix often restricted by the category of managed fun they belong to.

For example, a cautious managed fund is limited to holding a maximum 60 per cent in equities at any time, irrespective of whether it might be preferable to hold a significantly higher proportion.

Mark Dampier, of the independent financial adviser Hargreaves Lansdown, said: "Investors shouldn't be frightened of holding a reasonably high amount of cash if they are cautious. They can then couple this with an equity income strategy that should see them through in the long term.

"For example, Invesco Perpetual Income, Credit Suisse Income, Jupiter Income and M&G Dividend delivered the greatest income growth over the past 15 years.

"During that period, interest rates started at 15 per cent and came all the way down to under four per cent, so a strategy that uses cash only is a highly dangerous one. Investors who just plumped for cash would have seen their income fall by 70 per cent with no increase in capital value."

Choosing the right investments

As there are over 21,000 UK and offshore collective funds open to investment by UK-based individuals, selecting the optimum asset allocation, as well as the best funds to achieve it, can be difficult and time consuming,
However, many investment houses now offer fund of funds and manager of manager funds which make all asset allocation and fund selection decisions for you.

Discretionary management is regarded as the most sophisticated method of asset allocating and is appropriate for those investors with large portfolios who would prefer to have their assets invested directly into equities and fixed interest securities, rather than investing in collectives, and on an individual basis.

Andrew Barrie, Executive Director of risk-management company, Barrie and Hibbert, said: "Never has it been more important to provide robust analysis on investment portfolios to understand the likelihood of achieving individual goals and to ensure an appropriate mix of assets."