Asset allocation is the biggest determinant of investment returns. Here’s why taking the time to get it right matters.
Choosing investments on a whim based on current market conditions is unlikely to be a winning strategy in the long-run.
What should come first, and what is perhaps fundamentally more important than picking the right investments, is determining your asset allocation. How you divide your portfolio between shares, bonds and cash will have the biggest effect on how your portfolio will perform.
That’s not to say that it has to be an either-or choice between asset allocation or stock picking. Instead, investors should consider both components during portfolio construction and appreciate that asset allocation provides the structural foundations upon which an investment portfolio can be built.
The value of asset allocation
Research conducted by Vanguard found that on average, a portfolio’s underlying asset allocation explained the majority of its return variability over time. Market timing and investment selection on the other hand had relatively little impact on performance.
A carefully considered strategic asset allocation ensures investors are well diversified and building a portfolio that suits their risk tolerance and in turn, better protects them against market volatility.
By first deciding on an asset allocation strategy, investors are able to not only strike the right risk and return balance, but also assess market conditions, diversify and adjust expectations accordingly.
Asset allocation and risk
When it comes to choosing how much money you put into equities, fixed income, property or other assets, investors should first consider their risk profile.
Depending on investment goals, time frame and age, investors are able to choose generally between constructing a conservative, balanced or growth portfolio. A conservative portfolio generally allocates the majority of money to safer havens such as bonds, whereas growth preferences equities.
One way to manage portfolio risk is by selecting assets that have little correlation between them. Equities and bonds for example have close to zero correlation, whereas property and equities are more interlinked.
Equities and equities of course have perfect correlation. So those who see opportunities to capitalise on drops in equity prices over the last few years without considering their overall asset allocation strategy may well have picked up some bargains, but likely to have also ended up with many similar performing shares and little diversification protection.
Sub-asset allocation and home bias
Once the broader asset allocation strategy has been determined, investors can diversify again by turning their attention to sub-asset classes.
A primary way to diversify within asset classes is by selecting a combination of domestic and nondomestic investments. But as research shows, investors consistently display a significant home bias, opting either consciously or subconsciously to favour home-grown securities.
With all the uncertainty currently plaguing global markets, it’s understandable investors may flock to investments that they are most familiar with.
But with the ASX possessing a relatively higher composition of companies in select industries (i.e. banking, natural resources), it may be worth factoring in a reasonable level of global exposure when determining or reassessing your asset allocation.
So just like how each investor will have a unique investment goal, there is also not one standard asset allocation strategy that will suit all.
What should be consistent for all investors however is that asset allocation should inform what investment strategy is implemented. Without it as a guiding light, it becomes all too easy to let emotions affect decision making, to lean too heavily towards one asset class based on its short-term performance, and to let the current weather blow you off your investment course.
The above material has been reprinted with the permission of Vanguard Investments Australia Ltd