Asset Allocation

Asset Allocation

Providing Good Risk-adjusted Returns…

Asset Allocation is the study of how various asset classes and their sub-asset classes behave and how they might fit together in a strategic fashion.

At the core of asset allocation is the understanding of how an asset, its sub-classes or derivatives are expected to behave in terms of risk and return.  More importantly, an experienced investment manager will also sense how these assets might behave unexpectedly.  Developing this sense of the unexpected is down to experience; it takes a lifelong career in the markets to develop and is therefore under-regarded by many ‘teenage scribblers’.

In a whole net-worth portfolio, asset allocation means understanding the full spectrum of investment assets, themselves in a variety of markets, geographies and sectors and (if appropriate) a spread of investment providers with different strategies.

Diversification

Any portfolio manager who does not build in an element of diversification into his portfolio is either dangerously overconfident or a foolish novice. Asset allocation implies sensible diversification; creatively and imaginatively balancing risk and return – balancing the irresistible force against the immovable object.

Perhaps the most durable of all investment mantras is that Rule Number One is that risk and return are related.  Rule Number Two is: see rule number one.  Of course, we can achieve high returns at a low perceived risk and vice versa over specific periods of time – but guessing that will happen is not investment, but speculation.  In investment we are looking for some predictability of returns so that an investor can decide – by determining his risk level, what his return levels are likely to be.  It is diversification that mitigates risk while enhancing return and it is always finely balanced.

Diversification and segmentation  can be carried out on various markets, sectors, themes, strategies and currencies, all with particular tilts and weightings to suit the desired risk-return exposures) within the portfolio.  However the creative piece is to avoid the mistake that the inexperienced make, which is to diversify away their return through poor understanding of how the underlying assets work together, otherwise known as “di-worsification”.    If you can use your experience, there is no greater way to maximise returns (which of course comes from balancing your desired return with your bearable risk than diversification.

Segmentation

Segmentation is also a little known benefit of the asset allocation approach.  This consists of sub-dividing assets so that the tactical spin is more enhanced.  For example and Asian portfolio might be broadly segmented into five parts: Australasia, Greater China, India, Korea and the small ASEAN markets.  A tilt within the sub-asset class to suit the tactical asset allocation might add return within the sub-asset class without significantly increasing the overall risk to the asset class.

Core and Satellite

The Core and Satellite approach is  further technique for subdividing the portfolio, whereby the portfolio is designed strategically for the investor’s  core objectives (say a 60% portion).  The balance is invested into more satellite-orientated, or non-core assets that may be amended in weighting or in type of asset to suit market conditions.    This is intended to provide the portfolio with strong central stability while allowing a great deal of flexibility for market and timing allocations that may provide extra return at relatively little extra risk.

Diversification, segmentation and core-satellite strategies are critical but does not remove the euphoria or pain of investing – it is a balancing act: remember “no risk, no return”, “no guts no glory”, “no pain no gain”.   Somewhere in your investments you have to take a bet.  Always be critical and cynical but always be aware that a good investor knows when to suspend disbelief.

Asset Classes

I, like Winnie-the-Pooh, am a “bear of very little brain” and find it easier to remember that there are only five main asset classes – cash, bonds, equities, commodities and real estate and true alternatives like art or wine.  Sorry, hedgies and private equity, you are merely sub-asset classes of the above and in most cases are just applying an alternative strategy – rather than an alternative investment – to those key asset classes to modify volatility (or some other criteria) of return.

How the assets finally fit together within a final tactical portfolio is in the realm of the Portfolio Construction process, which is arguably the most important determinant of investment returns. Asset allocation is the top-down part of the Investment Process.

However before we get there, we must first go to the selection of investments (Investment Selection), which is the bottom-up part of the process.  Even completely bottom-up investment philosophies still have an element of top-down allocation and construction embedded in their investment process.

Indeed a true bottom-up process can only exist over time for an investor investing in a narrow, single sub-asset class field of the investment spectrum. We look at the whole investment spectrum and our investment is in essence a combination of top-down and bottom-up, seeking the best of breed in both areas in order to construct our portfolio.

For an indication of the current asset allocation incorporating all of our analysis of the investment markets worldwide see:   Tactical Asset Allocation by risk level

<<  Behavioural Finance     Investment Selection >>