Asset Allocation Revisited

In the past few weeks I have been reviewing some of the original posts in my ‘basics’ section. Asset allocation is one of the most important decisions every investor needs to consider if they are to be successful, so maybe an opportunity to update my blog.

It’s really a question of looking at the possible options where investments can be placed and deciding what proportion  to put in each one. The usual classes of asset are equities, government bonds (gilts), corporate bonds and fixed interest securities, commodities such as gold and silver, property and finally, cash.

Furthermore, equities can be divided into several sub-categories - large cap., mid cap and smaller companies, emerging markets, UK based or global.

Diversification by asset class and geography is one of the best forms of risk management.

As can be seen from Ben Carlson’s asset ‘quilt’, the fortunes of the various assets vary from year to year and it is impossible to determine which will do well in advance. Therefore, holding a diverse mix in your allocation strategy means you capture an average from all parts of the spectrum.

A good asset allocation is not so much about maximising returns, but more about building a robust boat that will ride out the stormy waters and get you from A to B.

Risk Profile & Volatility

When first starting out on the investing journey, I believe one of the least understood aspects is probably the need for every investor to understand their unique emotional make up and ability to withstand the volatility of the markets and then to match this to the most appropriate allocation of assets taking into account time horizon.

Successful investing is all about the long term so it is vitally important to ‘stay in the game’ for many years. It is therefore important at the start of the process to find an investment process and strategy that meshes well with your personality and temperament.

This is where asset allocation comes into play. Some assets such as equities and commodities are far more volatile than other more stable assets such as government bonds (gilts). Investors who invest 100% in equities are likely to get the higher returns over the longer periods BUT are more likely to throw in the towel when their portfolio loses 20% of its value in the blink of an eye…and go on to lose a further 25% over the following year.

In 2003, I came very close to giving up on my investing. My stellar gains from the dotcom period leading up to March 2000 were quickly eroded as the markets fell over the following 3 years. 2001 saw the 9/11 attack on the World Trade Centre, the All Share index fell 15% and the technology index fell by over 40%. This was the worst period for equities since the falls of 1973/74 when there was the oil crisis, coal miners taking on the Heath government and the ensuing 3-day week. The following year, the All Share index fell a further 25%!

With hindsight it was clear I should have sold my investments in early 2000 and repurchased in 2003 but timing these events is almost impossible to achieve. It was probably during this period when I was predominantly invested in equities, that I began to understand the importance of a sensible allocation of assets.

It will therefore be a good idea to have a robust strategy which takes into account our emotional traits and behavioural biases. The journey needs to be planned using a number of sound stepping stones and the first of these will be some attention to asset allocation.

Selecting a plan which contains a sensible mix of equities, bonds and possibly property and then being confident this mix can continue through periods of volatility and market downturns is key to a good outcome longer term.

Some Options

A classic allocation is 60% equities and 40% bonds. I am now in my early 60s and have been retired for several years and, as it happens, this is my current allocation. There is probably no such thing as a perfect asset allocation - each person should decide on the best mix, and of course, the mix between different classes of asset can, and probably should, vary over time. As you get older, the time horizon will obviously shorten so many will be looking to reduce equity and increase bonds.

One rule of thumb is to hold the same percentage of bonds as your age - so at age 30 years, it would be 70% equities and 30% bonds. At age 60 years, 40% equities and 60% bonds etc.

Tim Hale, author of “Smarter Investing” suggests 4% in equities for each year you intend to be investing - the remainder in bonds. I would go along with this suggestion but maybe for those of a more cautious disposition who require a more conservative allocation, reduce it to 2.5% or 3% for each year.

Another popular choice is the Harry Browne Permanent Portfolio allocation - 25% equities, 25% gilts, 25% gold and 25% cash. The portfolio is rebalanced once per year to restore any imbalance that has arisen as one asset class does better than another.

Personally, I’m not a big fan of gold, but I can understand why some people will hold a significant percentage in their portfolio as a hedge against currency devaluation. Others regard it as the ultimate safe haven in times of extreme uncertainty such as wars.

One of the benefits of spreading your investments across a number of different asset classes is the reduction of volatility. If you are invested 100% in equities and there is a sudden downturn in the markets, you could easily lose 20% or 30% of the value of your portfolio in a very short period of time - witness late 2008! In May, the FTSE was 6,300 - 6 months later the index had slumped 40% (2,500 points) to 3,800 by November. However, if your investments are mixed between equities, gilts and other fixed interest securities, it is more likely the loss will be more like10% or 15% which should make it a little easier to ride out the storm.

Whatever allocation you may decide is right for your investment approach, the main point is that you have addressed the issue. Also, I wouldn’t get too bogged down with 2% or 3% in this class and 4% in another - a broad brush is going to do the job and will be easier to manage and rebalance.

Many private investors start off with good intentions, but get sidetracked by the latest trend - with me it was technology shares in the late 1990s - but it could be smaller companies, emerging markets, commodities and so on, ending up with a dogs dinner of a portfolio.

Work Out Your Mix

First of all, it will to some extent depend on your timeframe - the longer the period, the more sense it will make to have a larger percentage of equities in the mix.

Some people are not very good at assessing the probability of a good outcome - they have unrealistic expectations of what they want to achieve for their level of risk and/or competence. They are sucked in by media stories or discussion boards - time and time again, we read about small investors piling into equities when the markets are near the top and just as quickly become disillusioned when the markets pull back as they always do.

Vanguard provide a useful online tool based on returns for the FTSE All Share over the past 30 years. You can play around with your preferred mix of equities/bonds (and cash) over various time periods to look at the % annual gains/losses during the period. Obviously the higher percentage of bonds in the mix, the lower the gains/losses - what level of gain would you sacrifice to protect against the downside?

Maybe you can take some guidance from Vanguard’s newly launched Target Retirement Funds. The equity allocation for younger people is 80% to age 43 years which gradually reduces to 50% at age 68 yrs and to 30% at age 75 yrs.

Their more conservative analysis starts with 70% equities to age 43 yrs, reduces to 40% by age 67 yrs and then just 20% equities at age 75 yrs.

As I say, there are no once-size-fits-all allocation - each will need to settle on their own mix. Of course, when just starting out, its very difficult to know just how you might react to a market correction of 15% or 20%. In his book ‘Investing Demystified’ Lars Kroijer suggests that if investors react badly to market falls, then reduce portfolio equity exposure by 10% - keep doing this until you feel comfortable.

Rebalancing

If I were in my 20s or 30s, I could well decide to choose 100% equities, after all, they are the most likely to provide the best return over the longer period. This is asset allocation - its just that I have chosen to allocate 100% to equities. The ride is likely to be volatile but may be OK for those with a strong constitution who are prepared for many ups and downs along the investing journey. Obviously there will be no need to rebalance.

Say I choose a portfolio of 50% global equities and 50% UK gilts  - and say at the end of the year equities have done very well and have increased to 60 % of the total portfolio value. This would mean the gilts now represent only 40%. The idea of rebalancing is to restore the original balance of 50:50, therefore I sell 10% of my equities and reinvest the proceeds into gilts. The overall value of the portfolio has increased but the original allocation percentages are always restored at regular intervals.

I am selling those assets which have appreciated in value, and then buying those that have either lagged or depreciated - it seems a little counterintuitive. If we're in a bull market and equities are going up, you have to sell some equities to buy bonds. It could be very emotionally difficult to do - equities may well continue rising for another year or two -  so I need to be disciplined and try to remove that emotion from the process.

The only sensible reason to do this is because of the investing principle known as reversion to mean. Whilst many forms of investments, including equities, can trade above or below their long term average - often for surprisingly lengthy periods - in the long term, they always move back in line with that average sooner or later.


Mechanics

With an ever increasing choice of low cost trackers - funds and exchange traded funds (ETFs), it is relatively simple to select a range of products to provide you with a fully diversified asset allocation to fit every possible option.

There are many providers however Vanguard alone offer many options for both equities and bonds - funds and ETFs. They have UK, Europe, US, Asia, Japan, Emerging Markets, Developed World. They offer many varieties of bonds - UK gilts, inflation-linked gilts and corporate bonds, global bonds, US treasury bonds, Euro bonds to name but a few.

However, the more funds you hold in your portfolio, the more complex the process of rebalancing. Some people are very organised and will remember to adjust the balance at the appointed time. Others may set out with good intentions but either forget or cannot bring themselves to sell the equities which have done well in exchange for poorly performing bonds.

Personally, I like to keep things simple and this is a big reason I have brought on board the Vanguard LifeStrategy index funds. They hold a blend of all the afore-mentioned equity and bond investments however for me, the big plus of these funds is they automatically rebalance the funds to maintain the desired exposure to equities. Therefore, for example, the LS60 fund will always hold 60% global equities and 40% globally diverse bonds.

Investing via the LS range is a simple but effective investing strategy - essentially a choice of selecting the level of allocation between equities and bonds, choose a suitable low cost broker - that’s just about it - job done, go fishin‘!

To Sum Up

My personal asset allocation is by no means perfect - roughly 60% equities and 40% bonds. I am still too overweight in UK shares and investment trusts but have been attempting to move to a more globally diverse mix with the introduction of the Vanguard LifeStrategy fund and other ETFs. However, it seems to be getting the job done and whilst not perfect, its good enough to ‘keep me in the game’.

When all is said and done, the “best” strategy for you is the one that you understand, feel comfortable with and importantly, can stick with in good times and bad.

Have a robust investing plan

Be sure the plan takes account of personality

Diversify by asset class and geography

Be patient, stay in the game and keep it simple

Feel fee to share your own strategies for coping with volatility and asset allocation generally in the comment below.