by Philip Baker 5 May 2017 Australian Financial Review
For all the time and effort that goes into working out if it’s National Australia Bank shares you buy instead of ANZ, or BHP Billiton rather than Rio Tinto, the more important question is whether you should be invested in stocks at all.
Call it the asset allocation process and it can determine most of what your end returns will be.
The focus is not so much which stocks you should buy, but more about the important decision of just how much of your money should be allocated to shares, bonds, property and cash.
According to David Walker from Stocks-In-Value and John Abernethy, managing director of Clime Investment Management, the asset allocation process is arguably the most important decision you will make, with 80 percent of returns coming from that decision.
That implies asset allocation is far more important than picking stocks.
The remaining 20 percent of returns is due to stock selection and tactical asset allocation within the chosen sector, which in itself is another process.
Setting the benchmark asset allocation involves understanding the characteristics of a number of investment types so they work in tandem to help reduce risk and achieve decent returns.
Of course it all depends on whether you are 20, 40, 60 or 80 years old.
If you’re starting out then shares could be as high as 80 percent of the portfolio.
Not that long ago all the consultants would have said if you’re closer to 50 years of age you should have around 40 percent in bonds.
But who can afford to do that these days ?
We’re living longer and returns are lower which means investors need to have more of their wealth in shares for growth and income.
There’s been all sorts of studies starting in the 1980s that have tried to explain just how important the asset allocation process is and as the years go by some more sophisticated modelling tools has been steadily reducing it’s importance.
Some consultants argue that what returns you end up with are related more to market movements than asset allocation and then finally which stocks are picked which is the active part of the process.
Look no further than what happened to shares in 2008 and 2009 and it shows just how large moves in markets can wipe out the effects of asset allocation.
But the GFC was a one off event. Hopefully.
There’s no doubt the portfolio’s “benchmark”, or strategic asset allocation plays a role as investors juggle their need for growth in the early years and income as they get closer to retirement.
Asset allocators are often looking at an investment landscape spanning at least five or 10 years, so expectations of nearby interest rate hikes or cuts will have little impact on this strategy.
It’s not unusual that over a long period of time there might only be eight or nine occasions when large asset allocation discrepancies develop.
The GFC would be one, high yields on US bonds early in the 1980s another, the late 1980s market peak in Japan, US real estate in the early 1990s, the Asian crisis, the dotcom hysteria in the late 1990s and bond yields going negative in 2016.
These examples are spread over more than 30 years but shifts in asset allocation – which some people may call market timing – will always be warranted if and when investors find these large dislocations.
Abernethy says that right now there’s not much growth in the equity market.
“From an asset allocation perspective, you’ve got to think broader than equities, but you are driven back to equities because the fixed interest market yields are so poor at present,” he says.
What’s also making the allocation process tricky right now is the spectacular performance of bonds over shares since 2007 and the low level of bonds yields.
“That’s a quite a unique period for markets and the problem is looking forward we’ve got a very low bond yield to start with and it’s very hard to see sustainable returns coming out of fixed interest or good returns to justify the risk of being there” says Abernethy.
Take bonds out of the asset allocation process and you’re left with property.
Given what property prices have done in Sydney and Melbourne you need to have a well-managed portfolio of assets.
One way to get higher returns is to accept a less liquid investment.
Original article here