Asset allocation: a beginner's guide

Asset allocation is a time-honoured investment method. It's how managers of big pension funds and many other professional investors pursue their goal of outperforming the market or matching their investment assets to their expected future liabilities. And it serves investors well.

There is, for instance, plenty of evidence from academic research that shows how sound the method is. It suggests that correct asset allocation can explain 90 per cent of a portfolio's return over time.

It has certainly worked for many private investors running their own portfolios. That's particularly so should you be inactive when dealing in individual equities and other investments, but focused more on getting the big decisions right. But asset allocation is not, as you might think, simply a matter of deciding between bonds, shares and cash. There are nuances. Should you be in emerging market equities, gilts or corporate bonds? Should you be in stock market investments or property? Should you have a weighting in gold or in other commodities?

There are limitations to asset allocation. It doesn't provide all of the answers, and it doesn't really help in selecting one fund or investment over another. It also won't necessarily protect investors from an economic cataclysm. In 2008, every investment vehicle bar government bonds went into reverse at the same time, including art, wine, and even gold. Gold suffered because, at a time when the need for cash was at a premium, investors sold gold simply to raise liquidity.

But, if you focus on it and get it right, asset allocation works. You need to monitor asset weightings (see table below for various weightings) regularly (a minimum of quarterly is perhaps the optimum), and make considered changes where necessary - if only to rebalance your portfolio for changes in the performance of different categories.

Another key aspect is to find several funds or other basic investments to use as core building blocks. These can then be supplemented where necessary to improve performance. This calls for broad-mindedness about the investment categories from which you select.

One school of thought is that, within the asset allocation framework, it's best to pursue a 'core and satellite' approach. This means a defensive, index-tracking core combined with smaller, more adventurous satellite selections to enhance performance.

The rational objective of correct asset allocation for individual investors is usually to ensure a smooth upward pattern of total returns, consistent with a given level of risk. Consistency and reliability are the watchwords rather than slavish adherence to a particular benchmark. But portfolios that use asset allocation need to bear in mind whether or not the investor requires income, and if so how regularly, and the level of acceptable risk.

Getting to grips with 'risk'

It is an investment truism that high risk equals high return and vice versa. What risk really means is not necessarily that an investment will fail completely and that an investor in it will lose everything, but rather the volatility that can be expected in the return from the investment. High volatility means a much greater chance that an investor might have to sell at a loss.

Whether or not you want to avoid such unpleasantness depends on a lot of factors: the degree to which you are dependent on your investments for income and as a source of capital, and especially age. Risk aversion tends to increase with age. Some investors are also just more cautious and risk-averse by nature.

But it's important to consider risk levels flexibly. Traditional safe havens such as government bonds and gold do, from time to time, become overpriced. If so, they may prove more risky than investors expect. A particular risk level can't be uniformly ascribed to a particular investment for all time.

If an investment appears to offer a high return without a commensurate level of risk being readily apparent, that doesn't mean the risk isn't there - it simply means that you haven't realised precisely what form it takes. Risk can be quirky rather than straightforward and obvious. Restricted liquidity, or not being able to turn an investment into cash at a moment's notice, may add to risk, for example.

The ETF advantage

Where today's investors have the advantage if they want to pursue a strategy that is oriented towards asset allocation is that the advent of exchange traded funds (ETFs) has made tailoring portfolios along these lines much easier and cheaper.

Index-tracking funds have been around for a long time, but ETFs are now available in much greater variety and cover all aspects of investing. They range from government bonds to high-yield bonds, in the US, UK, Europe and emerging markets, through to equity investments in most areas you can name, as well as property, commodities and precious metals, and even areas as esoteric as forestry and agricultural commodities.

What ETFs, which trade exactly like shares, offer is freedom from stamp duty, low management charges, and in many instances an income as well.

They needn't be used to the exclusion of other more traditional forms of fund investment, but they do make the task of creating a flexible asset allocation portfolio much easier than it used to be.

How Money Observer looks at asset allocation

Our model weightings in the Tactical Asset Allocator portfolio is based on different risk levels - high, medium and low. The higher risk model is likely to produce higher returns over time, but with significantly greater volatility than the others.

The medium-risk category is the one we use for the published portfolio, with some risk elements and growth ambitions, but also a tilt in the direction of investments that produce income.

The low-risk model is essentially aimed at conservative investors, with a greater emphasis on preservation of capital, a higher representation for bonds and cash, and reliable income generation.

Investors wanting to pursue a more adventurous or more cautious strategy can simply use the same or similar constituents in our published portfolio but tweak the weightings as required.

As the table shows, when looking at asset allocation decisions, we have gone for three separate equity categories - UK, other developed market equities and emerging markets - and three bond categories - government, mainstream corporate, and high yield.

The remaining categories, aside from cash, are perhaps what one might expect, property, precious metals and commodities, hedge funds and private equity, and other miscellaneous instruments, such as preference shares and convertibles.

We are also using specialist investment trusts if there is an obvious advantage to doing so, particularly for getting country exposure on the cheap.

Model weightings for our global Tactical Asset Allocator portfolio.
 Higher risk (per cent)Lower risk (per cent)Medium risk (per cent)Benchmark
UK equities15202042.5
Other developed country equities20102025
Emerging market equities3510200
Government bonds010020
Corporate bonds (ex. high yield)020100
High-yield bonds85100
Property and related10032.5
Precious metals/commodities5530
Hedge funds/private equity5045
other (eg prefs/convertibles)0500
* FTSE APCIMS Balanced index

We make every effort to ensure our beginner's guides are kept up-to-date. However, in the constantly shifting environment of investment and financial services, occasions may arise where elements of a guide become out-of-date. Please double-check the facts before taking any important financial decisions.

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