Thought Leadership

Asset Allocation

According to the well-known studies by Brinson et al., more than 90% of the variability of a portfolio’s performance over time is due to asset allocation.

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Introduction

As we begin to assess the needs of the family in terms of which investment manager to select and what style of investment (active v passive) I thought that I would begin the process by discussing asset allocation as an introduction to this topic.

According to the well-known studies by Brinson et al., more than 90% of the variability of a portfolio’s performance over time is due to asset allocation. Brinson is measuring the relationship between the movement of a portfolio and the movement of the overall market. He finds that more than 90% of the movement of one’s portfolio from quarter to quarter is due to market movement of the asset classes in which the portfolio is invested.

Therefore, choosing the right asset allocation, along with the right investment manager, has a very meaningful impact on the returns over time.

Active v Passive

This paper will not explore this topic, but for terms of reference I will briefly explain the difference below.  Suffice to say you can build the right asset allocation with either strategy, or both, so we can have this debate over time.

Active investing means investing in funds whose portfolio managers select investments based on an independent assessment of their worth, essentially, trying to choose the most attractive investments. Generally speaking, the goal of active managers is to “beat the market,” or outperform certain standard benchmarks. For example, if you’re an active US equity investor, your goal may be to achieve better returns than the S&P 500 or Russell 3000.  In market speak we call this “alpha.”

If you are a passive investor, you wouldn’t undergo the process of assessing the virtue of any specific investment. Your goal would be to “match” the performance of certain market indexes rather than trying to outperform them. Passive managers simply seek to own all the stocks in a given market index, in the proportion they are held in that index.  In market speak we call this “beta.”

The most favorable result may come from combining Active and Passive strategies.  There is more to the question of whether to invest passively or actively than that high level picture. Active strategies have tended to benefit investors more in certain investing climates, and passive strategies have tended to outperform in others. For example, when the market is volatile or the economy is weakening, active managers may outperform more often than when it is not. Conversely, when specific securities within the market are moving in unison or equity valuations are more uniform, passive strategies may be the better way to go.

Depending on the opportunity in different sectors of the capital markets, investors may be able to benefit from mixing both passive and active strategies, so the best of both worlds.  Market conditions change all the time, so it often takes an informed eye to decide when and how much to skew toward passive as opposed to active investments.  This is the role of the investment manager under our watchful eyes.

Some investors have very strong opinions about this topic and may not be persuaded by our nuanced view that both approaches may have a place in investors’ portfolios. If your top priority as an investor is to reduce your fees and trading costs an all-passive portfolio might make sense for you. In our experience, investors tend to care more about factors like risk, return, and liquidity than they do fees, so we believe that a mixed approach may be beneficial for all investors, conservative and aggressive alike.

As with many choices investors face, it really comes down to your personal priorities, timelines and goals.

What is asset allocation?

When people gamble on sports, they generally bet all their money on one team. If their team wins, they reap the rewards. And if their team loses? They lose it all. But with investing, you don’t have to bet on only one team, you can divide your money among different types of assets. This is what we call asset allocation. Done right, asset allocation safeguards your money and maximises its growth potential, regardless of which team is winning in markets.

Asset allocation is thus the process of dividing the money in your investment portfolio among stocks (equities), bonds and cash. The goal is to align your asset allocation with your tolerance for risk and time horizon. Broadly speaking, the three main asset classes are:

  • Stocks. Historically stocks have offered the highest rates of return. Stocks are generally considered riskier or aggressive assets.
  • Bonds. Bonds have historically provided lower rates of return than stocks. Bonds are typically considered safer or conservative assets.
  • Cash and cash-like assets. While you don’t typically think of cash as an investment, cash equivalents like savings accounts, money market accounts, certificates of deposit (CDs), cash management accounts, treasury bills, and money market mutual funds are all ways that investors can enjoy potential upside with very low levels of risk.

In addition to those three main asset classes, there are several other types of investable assets.  These include real estate (rental properties, farmland, and commercial real estate), commodities like gold, futures and other financial derivatives such as options, and futures. There is quite an extensive list.

NB: a portfolio can contain either single holdings, such as Apple and Google or funds which spread the risk over hundreds of holdings.  This would again be a topic for further discussion.

What type of returns can you expect?

Portfolio diversification is one step investors take to reduce their risk of suffering a permanent loss or enduring extreme volatility. Asset allocation takes that a step further by introducing less risky assets with lower volatility like fixed income.

For example, the table below illustrates how increasing an investor's allocation to fixed income can impact their portfolio's overall volatility and returns.

TableDescription automatically generated

As the table shows, a portfolio with 100% stocks delivered the highest average annual return compared to portfolios with some fixed-income allocation. It also produced the best overall year. However, this hypothetical portfolio also endured the most years with losses and the biggest one-year loss.

As investors increased their allocation to bonds, in this case, they reduced their overall average annualised return. However, they also reduced risk, as evidenced by the lower loss in the worst year and fewer years with losses. Higher allocations to bonds generated some bigger one-year returns compared to a more balanced portfolio. Meanwhile, a 100% bond allocation led to a greater number of years with losses than some more balanced portfolios.

Adding other asset classes to a portfolio can further reduce its overall volatility while improving returns. For example, a traditionally balanced portfolio (60% stocks and 40% bonds) has produced an 8.15% average annual return over the past 30 years.  This portfolio had a standard deviation (a calculation of annualised volatility) of 10.68% and a Sharpe ratio (a risk assessment based on the volatility of a portfolio's returns to a risk-free asset like short-term Treasury bills) of 0.76.

However, adding 10% allocations to real estate and farmland while dropping the stock and fixed-income allocations to 48% and 32%, respectively, yielded a higher total return (8.46%) with less volatility (8.62% standard deviation) and less risk (0.98 Sharpe ratio) during that time frame.

Asset allocation by risk tolerance

An investor's risk tolerance, or their ability and willingness to lose some or all of their investment in exchange for a higher return potential, is an essential factor when determining asset allocation. Given that mixing in different asset classes reduces a portfolio's risk profile, investors with a lower tolerance for risk (no matter their age) should consider having a higher allocation to less risky assets such as fixed income and cash.

They also might want to consider other asset classes with less correlation to the stock and bond markets like real estate and commodities such as gold to further reduce their portfolio's risk profile.

Conversely, investors with higher risk tolerances should weigh their asset allocation more toward equities like common stocks.

Risk tolerance can be a state of mind as some people are more risk-averse than others. Meanwhile, life stage or future planning also play a role in determining risk tolerance levels.

An older investor might have an extremely low tolerance for losses, leading them to have a higher allocation to less risky assets.  A younger investor for example might not have this issue.

There is no one-size-fits-all asset allocation strategy

Asset allocation plays a vital role in an investor's overall experience since there is a lot of correlation between assets in the same class. However, there is no standardised asset allocation strategy for all investors.

Instead, an investor needs to personalise their asset allocation to ensure they have the right mix of asset classes for their risk tolerance and age. Doing so will improve their investing experience by reducing their portfolio's overall volatility while still producing acceptable returns.

Along with the appointed investment manager we will help each family member asses their own levels of risk appetite, and their aptitude to accept a loss, and create a bespoke portfolio for all of you.

Mark Estcourt

CEO

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