Asset allocation is the foundation of every portfolio and is generally considered to be the most important of all investment decisions. As each asset class, such as stocks and bonds, offer a trade-off between risk and return. The objective is to balance the need for acceptable returns with exposure to the appropriate level of risk.
Investors should ensure whoever is looking after their assets has a well-structured process for determining asset allocation. This starts with a Client Questionnaire. Individual circumstances, needs and preferences provide the portfolio manager with insight into the optimal long term investment structure.
After determining the appropriate core allocation, each portfolio should be tailored to your unique attributes such as overall wealth, investment attitude, specific needs and financial situation.
A core objectives of money managers is to provide diversification to minimize risk.
A detailed analysis helps determine which asset classes provide true diversification by way of weak correlations.
Investors should at least consider every asset class in order to determine which should be included. The most commonly chosen are; cash and short maturity bonds, government bonds, investment grade bonds and developed market equities. Cash and short maturity bonds are at the core of most portfolios as they are the only investments that fulfill the objective of maintaining capital values.
However these asset classes are not entirely risk free because their return may not maintain purchasing power in an inflationary environment.
Government bonds with credit ratings of AA- or better help stabilize portfolio values as returns are less volatile and bonds prices tend to move in the opposite direction of stock prices. In general, when the business cycle is weak, stock prices fall and interest rates tend to decrease, driving up bond prices. A caveat is that this can break down when inflation is much higher or lower than anticipated.
Investment grade corporate bonds (credit ratings of BBB-) also offer stable and somewhat countercyclical returns while providing additional yield to compensate for the credit risk relative to government issues.
The other most commonly used asset class is developed market equities. They are significant because over the long term European, North American and Pacific Rim companies have created more wealth for investors than any other liquid asset class. The key words here are long term because equities have had a rough ride over the last 15 years and bonds have outperformed most equity markets during this period.
Many investors have considered this recent poor performance which was caused by increased volatility and would prefer to avoid equities. Looking forward equities continue to offer excellent return potential and while it is important not to infer too much from recent historical experience, client concerns about near term volatility must also be considered.
An analysis of asset classes would not be complete without considering the full range of asset classes such as high yield and emerging market bonds, emerging market equities, commodities, real estate and alternative investments which include private equity and hedge funds. While most investors are constrained from holding large positions in these classes, they can obtain some indirect exposure with conventional holdings. High yield bonds, which used to be called junk bonds, and emerging market bonds simply do not have a sufficiently high credit rating to be held in an investment grade portfolio.
Emerging market equities are interesting as it is expected they will account for an increasing share of the global market but they can be illiquid which constrains investment. Exposure can be obtained to these growing markets though through multinational companies headquartered in developed markets.
Similarly, exposure to commodities, especially in the Canadian market, can be obtained by investing in companies operating in the materials and energy sectors. As well, real estate can be accessed through indirect investments, such as Real Estate Investment
Trusts (REITs). Alternative investments, which include private equity and hedge funds, are really only available to the largest of accounts due to extreme illiquidity and the wide dispersion of results across managers which necessitates a rigorous and ongoing monitoring process.
The next step in the process is to consider forward looking returns for each asset class. The ‘rear-view mirror’ approach is often used by unsophisticated investors who simply purchase whatever asset recently turned in the best performance.
For example, bonds have done well as interest rates declined over the past 20 years but with interest rates now at near zero levels in many countries it would be illogical to assume long term government bonds will continue to do well in the future.
Your money manager should utilize reliable estimates of the expected future average return for various asset classes, as well as the uncertainty surrounding each return estimate, to help formulate a view of valuation trends. The asset return estimates over the next five years and longer gives a forward looking view on the markets and is the final ingredient required to make the optimum asset allocation decision.
Of course nobody knows with certainty what will occur over the next five years but we do have an idea of the range of probabilities which will help mitigate risk in a way that is consistent with what matters most to investors, diminishing the chance of a bad outcome.