Asset Allocation: What's it all about?

The basic premise behind asset allocation is that it is generally accepted as being the most significant factor behind the performance of investment portfolios. At its highest level this is literally the split between growth (equities) and non growth assets (cash and fixed interest). There are other factors including market timing, stock selection, momentum, value tilts, smaller company tilts etc. which have varying degrees of significance. Significance is used in this case to mean statistically meaningful or measurable.

The rationale for investing in anything other than risk free (e.g. cash/Treasury Bills) is to make extra returns. Therefore the more that you add to risky assets the more you should reasonably expect to make above risk free over time. A very basic asset allocation model could therefore be to simply have a split between a UK FT All Share Index Tracker and say Cash/Bonds. The more you add to the Tracker the more risk you take but the greater the returns you expect.

You could also add a Value and/or Smaller Companies tilt if you believe the evidence provided by French and Fama that, in return for additional risk (above just investing in the market as a whole), these two factors have demonstrated a tendency to generate additional returns (in excess of the market as a whole).

A decision that you will need to make is whether to take some fund manager risk. Obviously the reason why you would do this is because you believe that there is empirical evidence to indicate that you should make some extra profits in return for the extra risk and cost to which these expose you. Most readers will already be familiar with my views on this. For now I will simply quote from the FSA Occasional Paper on the Price of Retail Investing page 47 'That is, it appears to be the case that, on average, resources devoted to actively managing a fund do not create any off-setting improvement in fund performance'.

We are all familiar with the term diversification but do we really understand what this means? It does not just mean splitting a portfolio between different fund manager's offerings so as to avoid having too many 'eggs in one basket'. Rather, it is the method by which you blend asset classes which behave differently to each other in order to reduce the risk profile of the portfolio as a whole. It can be demonstrated that if you take a number of asset classes with given risk levels (typically measured using the standard deviation) that the risk profile of the portfolio composed of them will frequently be less. So it is useful, when constructing a portfolio, to ensure it contains a range of asset classes which behave differently i.e. they are uncorrelated.

Asset classes which tend to be fairly uncorrelated with equities include property and commodity futures. Both of these can be accessed via collective investments such as OEICS and Unit Trusts as well as Exchange Traded Funds.

Interestingly, alternative investments such as hedge funds appear to potentially have the potential to substantially worsen potential portfolio returns and make their risk profile increase rather than reduce overall. This is before you take into account the relative lack of information about what they actually do or the very high charges levied by them.

You will also need to decide on the extent to which you bias the portfolio (if at all) in favour of the UK market. In general if you are dealing with UK based investors you may want to increase the weighting to UK equities beyond their actual weighting as a function of the value of world markets as a whole. If you are dealing with expats, either non Brits or maybe Brits who are likely to retire abroad you have to ask yourself whether a portfolio with an overweight UK allocation would be appropriate.
There is no hard and fast rule about exactly what splits you should adopt. In general it is better to have any asset allocation strategy than none. Once you have adopted your asset allocation strategies you need to periodically rebalance the allocations to ensure that the risk profile of the portfolio is maintained. There is evidence that many private investors loose substantial sums by chopping and changing and following the market when they would have been better off simply adopting a long term buy and hold strategy.

A good source of information on asset allocation as well as many other aspects of investment is IndexInvestor.com and in particular this article.. I would also very much endorse Tim Hale's book which you can find here. I have also found this presentation given by Tim on Asset Allocation which you may find useful.

One final point on this. You will always find conflicting views on the most effective methods of investment and many of these will be given by extremely credible people. All I can say is that you have to look where the weight of the arguments lie and then take a view.