It is a well established fact that asset allocation is responsible for more than 90% of variability ...
It is a well established fact that asset allocation is responsible for more than 90% of variability in returns from a global, multi-asset portfolio. Despite this, many advisers still adhere to the alchemist's route to investment success ' avoid higher risk markets, have a 'home market bias', and spread the investment across a number of funds from star managers. This so-called 'cherry-picking' approach is risky; if you are lucky, and equity markets go your way, a number of fund managers will be out-performers. But remember, fund managers are human (mostly). It is all too easy to be self-congratulatory when funds do well, but blame the market when they do not. How much of a fund manager's performance is down to luck, and how much stock-picking skill?
If you take 1,000 fund managers who were all slow losers ' guaranteed underperformers over time ' after four years, by chance alone, 41 would have made money in spite of themselves*. These 'lucky' managers would look like geniuses; we would then hang on their every word, eager to drink at their well of knowledge. New investors would be persuaded that these were the ideal managers with whom to invest. In year five, half of the 41 would bomb. Would we call them unlucky? Would we give them another 12 months to get back to winning ways? After all, they are skilled when markets rise, and unlucky when they don't.
Whatever your view of a fund manager's ability, it is undisputed that active management scores when market volatility is high ' share returns are all over the place ' because there are lots of good stocks to buy and bad ones to avoid, so it is easier to beat the market. When the market is stable, stocks are stable, so returns are similar. Low volatility means a stock-picker's job gets harder. And guess what? In the last six months, the annualised volatility of the FTSE All Share index has more than halved.
Asset allocation as a starting point significantly reduces the risk of being at the mercy of skill or luck. It is a recipe; risky assets are combined in such a way as to cancel out the respective peaks and troughs of the underlying funds. Critics point out that this approach can result in a portfolio which appears to be uncomfortably high in international equities. However, the maths tells you not to view funds in isolation; an asset allocated portfolio is less risky than the sum of its ingredients. In fact, a portfolio which is 87% exposed to overseas equity (for example, for a higher expected return target) may have the same risk as UK equities, but with a higher expected return. Another charge is that investing in overseas funds adds currency risk. This is a myth; exchange rate risk does not add much to equity risk. In fact, if the exchange rate is less volatile than the fund, or their covariance is negative, overall risk is reduced**.
Whatever you feel about the current investment outlook, 'cherry-picking' funds without a calculated asset allocation process is adding unnecessary risk. A portfolio optimised for both asset allocation and tax efficiency is a recipe for investment success.
* Source: Fooled by Randomness, Dr Nassim Nicholas Taleb, as reported in Investors Chronicle 4 July 2003
** Source: Optimal International Asset Allocation with Time varying Risk ' TJ Flavin & MR Wickens, Journal of Finance November 2001
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