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Asset Allocations. Don't build your house on a sandy land...

2 | The Professor | 2010/03/06 | Print |
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Asset Allocations. Don't build your house on a sandy land...

A conclusion from the asset classes blog entry was that investing in Equity potentially delivers great long-term growth but comes with a health warning, whereas Fixed Income has a moreconservative ‘risk-return profile’.

So, say the only two asset classes there were in the world were Equity and Fixed Income (which is not the case!): If you want to grow your money as fast as you can - and think you can afford to stomach some wild gyrations - should your portfolio consist only of Equity? Or, say the prospect of seeing your investments potentially suffer a big loss scares the hell out of you, should your portfolio consist only of Fixed Income?

No and no!

Why? This is where investing gets interesting, if a little counter-intuitive. If you identify with our young buck in the in the previous paragraph who's looking for maximum growth, by putting just some of your money into Fixed Income you'd actually make more money in the long-term. Incredible? Yes. Similarly, if you're numb at the prospect of losing money, putting a small allocation to Equity in your portfolio can actually make the portfolio less risky than if you'd invested every last cent in Fixed Income.

Equity and Fixed Income have completely different ‘performance drivers’. For example, while economic growth and innovation are primary drivers of the performance of Equity, interest rates and inflation are the dominant performance drivers of Fixed Income. And since innovation, for example, is really quite unrelated to interest rates, these asset classes perform in different ways at any given time.

Getting a bit more specific, Fixed Income generally performs well when Equity performs badly, and vice-versa. For example, government bonds had a bumper year in 2008 when most-else crumbled. Look at the graph below, which shows the returns for Equity and government bonds (Fixed Income) for each year in the ‘noughties’.

Negative Correlation

Notice that the best four years for Fixed Income correspond to the worst four years for Equity. This is known as 'negative correlation'. Why does this matter? Herein lies the nub of investing...

The key is to invest in asset classes than behave in different ways – where one zigs while the other zags – like Equity and Fixed Income in the graph above. This is the basis of 'diversification', a term you might have come across in finance.

So if instead of investing 100% in Equity one might choose to invest, say, 90% in Equity and 10% in the 'more boring' Fixed Income, you'd actually could make more money over the long-term, and with less risk. (This is a remarkable thing of beauty. The concept won the Nobel Prize for Economics, no less!)

With your Brussels sprouts now painlessly digested, we've happened upon the topic of this blog entry: Asset allocation. This combination just mentioned, of 90% Equity and 10% Fixed Income, is an example of an asset allocation (albeit a simple one). Low hanging fruit is always the sweetest.

Wikipedia says that an asset allocation is "the strategy used in choosing between the various kinds of possible investments, in other words, the strategy used in choosing in what asset classes (such as stocks and bonds) one wants to invest". Asset allocation = how you allocate your money to different asset classes.

But you may ask, “Is this asset allocation consisting of 90% Equity & 10% Fixed Income the magic combination? It seems a bit arbitrary and random doesn't it?”

Yes, it is. Determining the right asset allocation involves a lot of maths and financial theory.

And, you should know that there's no one right asset allocation for all - so don't go thinking that Google can help.

It depends on you – your age, income, needs, objectives, constraints, fears, dreams. Investopedia hits the mark in saying that an asset allocation is "an investment strategy that aims to balance risk and reward by apportioning a portfolio's assets according to an individual's goals, risk tolerance and investment horizon."

Below you can see the ‘risk-return profiles’ for three simple asset allocations. “Safety first” corresponds to an asset allocation consisting of 90% Fixed Income & 10% Equity; “High roller” is 90% Equity & 10% Fixed Income; and “Moderate Risk” is 30% Equity; 40% Fixed Income & 30% Commodities. The risk-return estimates for these asset allocations are forward-looking, based on Spotlight’s asset class projections. You can see that the higher the return you look for, the more risk you need to take.

Risk-Return Profiles of Simple Asset Allocations

So, it's not as simple as buying a few stocks that you know and love. Smart investing is about using your needs and objectives to construct an appropriate asset allocation that you understand and can expect to deliver.

Having read this, you now know more about intelligent investing than most – including those at companies who are trying to sell you funds and investments that really only they benefit from. And, more importantly, you're well on your way to taking control of your financial destiny.


2 | The Professor | 2010/03/06 | Print |
  Back to all posts
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