|'Asset allocation' is the hardest
subject in investment. It is also the most important.
The show so far
In Simple Investing we encouraged you to:-
- Understand the need to take some risk;
- Control that risk by finding a suitable (for
you) balance between cash and shares;
- Spread that risk by diversifying.
Diversification, we introduced correlation and the principles
of diversifying among shares. Now we ask: can we benefit by diversifying
among asset classes - expanding our potential list of assets from
the two classes of cash and shares?
This process is called 'asset allocation'.
We list nine asset classes in the assets
section of this site. These are cash, shares, bonds, index-linked
bonds, premium bonds, property, buy-to-let, commodities and collectables.
You may be quite happy to stay with the cash/shares mix you have
found. Or you may want to try adding a third asset class.
There is nothing magic about the process now. You
have to decide how much of your preferred third class to buy and
what proportion of cash and shares to replace in your portfolio.
You will be guided by the expected return on your
chosen third asset class. To maintain the risk profile you are comfortable
- a high return will indicate high risk and
you will want to mostly give up high-risk shares;
- a low return will indicate low risk and you
will want to mostly give up low-risk cash.
You should end up with a new portfolio you are comfortable
with, and maybe a bit of extra diversification. Against that you
have the complication of managing a third asset class.
Adding a bit of science
You may be thinking all this is a bit ad hoc
and there ought to be a scientific way of doing all this. and there
is. It is called Portfolio Theory.
We have mentioned 'correlation'. The concept
can be expressed mathematically, such that between any pair of assets
there is a correlation coefficient. If you run all these numbers
through a computer and tell the computer what level of risk you
are comfortable with, the computer will spit out an investment portfolio
(or a family of portfolios) that will give you the highest return
you can get for that level of risk. These are called efficient
It gets better. It seems to be a characteristic
of efficient portfolios that they include a small dash of 'unconsidered'
asset classes- that is, classes that do not seem to be particularly
attractive investments in isolation.
It is hard to see, intuitively, why this might
be so. The best explanation we can give is that the 'unconsidered'
asset has low correlations with cash and shares which allows the
computer to substitute mostly low-return cash without increasing
the risk of the portfolio. But generally, we must admit that if
you can't do the maths (and very few can) you'll have to take this
Which raises the question....
- why don't we entrust our money to a Fund
that has the expertise to find the efficient portfolios for us,
- why don't we use the information provided
by fund groups, who may, for example, advise us that their computers
show that 5% in some alternative asset class added to a standard
portfolio will both increase return and reduce risk - the holy
We spend time on this because these are extremely
persuasive sales pitches and you need to understand why you might
...and the answer is.....
There are a number of of contrary factors:-
- Garbage In, Garbage Out applies. There is
a correlation coefficient for every pair of assets in the model.
With 10 assets, that's 45 coefficients. That's 45 forecasts
of how two assets are going to relate to each other in their
future performance. You might think that if someone is clever
enough to get that right it would be easier just to forecast future
returns and pick the highest.
- The maths assumes that correlation coefficients
are fixed over time. There is no reason why that should be so.
In fact there is now some evidence that correlations increase
in bear markets - in other words, diversification benefits break
down just when you need them.
- There's a management trap called 'Managing
to a Model' and you are in danger of falling into it. Portfolio
Theory constructs a model of the investment problem and optimises
it. The results provide insight; but they don't provide answers.
It's only a model - a simplification. It uses just one definition
of risk, for example.
- As always, you have to consider the cost
of taking advantage of a perceived benefit. The sorts of improvement
we are looking for here are maybe an extra return of 1/2% for
the same degree of risk. That is well worth going for over a long
but only if the costs of doing so are less than 1/2% per annum.
Which they won't be.
Do it with shares
You can get quite close to some asset classes
by buying shares. If you want some exposure to property, buy property
shares. If you want some exposure to commodities, buy mining shares.
If you want some exposure to corporate bonds, buy gilts spiced with
a few equities.
Other ways of slicing the cake
A reminder to finish with. It is easy to get
hung up with asset classes. You can slice up the whole universe
of investible assets in any way you like. Every way gives you a
different way of looking at things, a different set of decisions
and, if you are not careful, another way of persuading you to lose
the wood for the trees.
Stay with first principles - you need to invest
in a range of different stuff, but the benefits of diversification
fall quite quickly, and the complications increase, as you add more
This is the most important investment decision
you have to make. If you get that right, you are 95% of the way
towards a proper savings plan.
What assets do I chose
There is no commandment that says assets must be grouped in a particular
way. But it has become conventional to focus on four asset classes:
cash, property, bonds and shares. Most savers will restrict their
investments to these four.
Commodities and collectables are two other
groups worth mentioning. Though we don't recommend them.
Can't we divide groups
of assets with finer cuts?
Well, yes. We don't really want to do it, because we think you should
keep it simple. But we will mention some common subdivisions:
- In property: your own house(s), retail ('buy-to-let')
- In bonds: UK government ('gilts') and 'other'
(foreign government, investment grade corporates through to junk
bonds). Perhaps the most important: index-linked bonds (a subset
- In shares - too many to mention.
- In commodities: gold and 'the rest'.
What do we do now?
Get some specific advice. And the best of luck. Ron Sandler (he
of the influential Sandler
Review), in his submission to the Treasury Select Committee
(News Bites), opines: "there
is almost universally no attention given to asset allocation by
advisers in this country. Their focus is on product purchase."