Thursday, April 2, 2009

Asset Allocation - Investing By The Numbers

What is asset allocation and how can it make you a better investor?

I've been reading a lot about asset allocation lately. I don't recall what prompted this sudden interest. Perhaps it's a factor of age. My investment strategy has always been heavily skewed towards Australian shares, for a number of reasons, but mainly because shares traditionally have a good return when compared to other asset classes and although they are more volatile, since retirement is still a fair way off, I was happy to accept the volatility in exchange for higher returns. However, while retirement is still a fair way off, it's still something which I need to take seriously as the recent fall in world stock markets would have been disastrous if I was about to retire.

The idea behind asset allocation is that you spread your investments across different asset classes where the risk profiles are different and the returns aren't perfectly correlated. In this way, you're taking advantage of diversification to spread your risk while at the same time you're smoothing out your returns as your investments in different asset classes grow (or sometimes decline) at varying rates at different times (to each other).

What all of this means is that (hopefully) not all of your investments will perform poorly at the same time.

What asset classes can you choose to invest in? Well this depends on how exotic you want to get. Normally, you would be choosing from equities (shares), real estate, fixed interest (bonds) and cash. However, you may break shares up according to size (ie. small cap and large cap) or by region (Australian, American, European, Asian, etc). Real estate may be broken down into residential and commercial or industrial.

Strategic Asset Allocation

Strategic asset allocation involves setting fixed percentages of your investment portfolio to be invested in each asset class. For example, a more aggressive investor might choose something like the following:

40% Shares
30% Real Estate
20% Fixed Interest
10% Cash

The above is just an example. To work out your own asset allocation, you need to consider a number of factors like your tolerance for risk, the term of your investment (are you saving for retirement or a deposit for a house?) and your stage in life (the older you get, the harder it is to recover from capital losses).

Over time, your actual portfolio will tend to move away from its original allocation. Investments will grow at different rates causing them to make up a larger or smaller percentage of your portfolio than was originally intended.

This is where portfolio re-balancing comes in. The idea is that as the value of each of your investment becomes skewed from the original allocation, you buy or sell in order to maintain the correct weighting. I like this idea as it means that you're selling down something which has outperformed and buying into something which is theoretically cheap. It also makes the decision to buy or sell more objective.

Tactical Asset Allocation

If you're not a buy and hold kind of person, then a tactical asset allocation model may hold more appeal. You still have your ideal or planned weightings for each asset class but under this model you may choose to move away from these targets for short periods of time to exploit pricing or other factors which lead you to believe that a particular asset class will outperform.

While I've read that any out-performance is purely theoretical in nature and difficult to achieve in practice, what I like about asset allocation as a methodology is that it provides a framework for investors. If properly adhered to, I think it can take some of the emotion out of investing.