What personal investors don’t use but should….

Asset allocation. This is the science about how much of your money is deliberately allocated to different classes of investments at any point of time. An investment class is simply a category of investment. Shares, property, Bonds, cash, commodities and financial instruments (derivatives). Whilst professional fund managers tasked with managing investment funds for governments, pension and super funds and the like, place much thought and skill in doing this, most individuals do not.

So why do they? Different types (classes) of investments behave differently to each other in certain time frames and conditions. Conditions include how an economy, industry or all other investors are operating in that investment class at any particular point of time. How an investment class responds to these factors alters how specific investments within that class also behaves.

Over time patterns evolve. These patterns most often repeat themselves over longer periods and when you study this behaviour they can either add to, or subtract to your returns. It can also do the same with the amount of risk you take in investing in each type of investment class.

How mixes of classes behave together is an opportunity. Additionally when you look at how one class of investment behaves versus other classes at a point in time it can deliver beneficial outcomes if you get the mix between classes right. This is because mostly (not always) investment classes will behave differently from one another in long term patterns of repetition of predictable performance.

The aim is not to always have all your investments moving up (although isn’t it a nice dream), but when looking at them as a collective- a portfolio, the overall portfolio is moving along nicely. You only require a net number to be moving up and more so than those heading down. Whilst some or all of your investments bounce up and down in value, as a whole the return and its pathway of moving up is sound. Counter intuitive isn’t it to accept that at any time some of your investments may be performing poorly over 3 month to 2 years’ time frames? This is a key to longer term success however.

The result? Understanding this can lead to better longer term performance of all your wealth over time and often with less risk needing to be taken by you. Since modern investing evolved in the mid 1950’s lots of analysis by experts has been done on its benefit. What they found may seem counter intuitive to being a good investor. Certainly the media and so-called investment guru’s don’t talk about this all that much. Perhaps it doesn’t make good headlines or sells lots of books.

By investing in a mix of major classes and holding this allocation (called ‘strategic asset allocation’), investors only had to achieve an average return from each of their individual investments (compared to all returns achieved in that investment class- e.g. shares or property), in order to achieve an above average overall return on their wealth.

Why is this so? The law of averages means over time an individual cannot perfectly time the following over longer periods: What to buy, when to buy, for how much, hold for how long, when to sell, then what to do with the proceeds all over again. Each investment, each time, year in year out.

ALL people on this planet will get these calls wrong quite a lot. Professional investors will get this less wrong but still will. This is because we are human. We are not immune to bias, emotionally reacting ego, arrogance, greed, fear and old fashioned ‘punting’. In the end the House Wins! Investment returns over time revert to their long term historical average. You may for a few years do better than others in certain shares or property investing but long term all your calls will add up to the longer term average. Never forget the never ending impact of mathematics, history and human behaviour.

Caution: Investing in and out of things often IS NOT INVESTING. This is speculation. Be careful accepting the stories of high returns from others who do this. The classic example is the get rich easy schemes promoted for day trading and Forex trading. Over time they will fail. Nothing wrong with speculation but its high high risk and requires lots of time and know-how to do it well. If you are building wealth long term for yourself and /or your family long term is the game and that means investing.

A major factor impacting our decisions is rarely considered as personal investors. All the types and degrees of risk attached to each investment we make. Quality risk, timing risk, market risk, currency, political and economic to name just a few. We usually make investment decisions on only one half of the Return equation, the earnings part. How much our investment goes up in value and any income produced. The equation has to how ever two addends to the sum. Return = Earnings + Risk. Knowing what you are exposed to and how to easily reduce , though never eliminate them, is a key to obtaining a return over time above the average. Using considered Asset allocation is a low cost, no fuss and effective way of obtaining an above average return over time WITHOUT having to make every investment a winner and getting your timing perfectly right all the time.

Why should I also do it? Simply because you can! Think of it as free risk reduction and free extra returns without all the stress and angst.

What about the actual investments I make? Its still important to invest in quality and not get caught up with Leeming type behaviour around greed and fear. The impact of tax is still important so as to retain as much of your return as practical. As are costs in purchasing and maintaining your investments. What you don’t have to do however is try to deliver much bigger and higher returns all the time… with a statistical likelihood of failure.

No one asset class is always superior to another over short and medium time periods. Over very long periods shares outperform on average all other classes. Property tends to be next. But Bonds (debt) and Cash have very worthwhile and beneficial roles to play in your portfolio. You may invest direct or via managed funds and usually a mix to utilise asset allocation well.

The studies show over time an average return is all that is required for most people. IF you get Asset Allocation working for you. Getting an average return is much easier and far more likely, so that’s great news!

In earlier blogs I mentioned the requirement that nearly all of us only require to be a Good Investor, not a Great Investor. Great investors are on the path to defying investments equivalent of Newton First Law of Gravity. It’s hard to achieve, its complex, it requires great skill and a lot of your time. Not to mention a lot of luck. It’s also a lot of extra risk and stress . A Good Investor can use Asset Allocation to deliver the longer term outcome they need. Simply trying to gain the ‘best’ return or the most return is hard and may not even be required for the goals you seek. Thus personal investors need to think about….”How much is enough?”

The science of investing has produced several sound asset class models you can utilise in allocating your money based on 50 years of patterns and trends. It requires a steady hand when an investment market falls in value and all the news on your screens are pronouncing doom and gloom.

Strategic asset allocation only changes to fundamental changes in the world. For example a change to the taxation of property or shares would result in a model being re-positioned for this change. An economy hitting hard times is not a fundamental change or is a market falling or rising in value. These are generally cyclical in nature and for the asset allocator, you ride them out each time. Sit on ones hands so to speak! This is the only hard part and here’s why….

First it’s against how we are programmed as humans- flight or fight. Second the maths involved mean you will be moving money out of your investments in asset classes that are rising into the ones that are falling or staying static. This is counter intuitive but it works. This part of the process is called RE-Balancing. If not your model allocation will go out of kilter over time reducing its effectiveness.

Enter Tactical Allocation. This is where you alter your strategic asset allocation only temporarily to a current situation that once passed, you revert to the strategic model. More risk here as you have to get the timing right (but not as much in buying/selling individual investments). For example when markets blatantly over react up or down and it’s blindingly obvious (assuming you can remove your emotion from your view) then you would make a temporary adjustment. Again there are many free sources of quality models. The aim is more to limit downside losses than exploit upside returns. For those in retirement this is very important as it lengthens how long your funds will be able to produce an income.

What do I need to do?

1. First accept that at any time some investments and even an entire asset class of your wealth portfolio will be going down or sideways. Sometimes for a year or two. Assuming the actual investments held are quality then you need to ignore this and keep to the weighting your model said you to have.

2. Rebalance regularly despite if markets are up or down. You only need do this around once a year. Studies again have shown any more frequent rebalancing produces no extra return, any less and you lose effectiveness.

3. Learn to sit on your hands…and Know thy Self. We are human, we will be swayed by things that will work against our money- not help it.

And Google ‘Balance Portfolio Theory’. The facts and science is there for those readers that require proof before acting. Global Research firms such as Russell, Morningstar and Mercer produce excellent models you can use and publish them often.

Asset allocation isn’t the be all and end all of solutions to achieving above average returns but should be a major ingredient to the investments you will hold and produce wealth from. It provides no guarantee but will likely produce better long term returns with less effort and risk and angst along the way.