Problems, problems, problems. That’s all that appears to be ahead for global stock markets.
That’s certainly what much of the media would have investors believe – and perhaps one of the reasons that despite all-time highs in markets, investors feel unhappy.
The real problem for investors is not market uncertainty – that will always be with us. Instead, it is the pervasive negative noise about investment markets – which lures investors into believing that their best bet is to react to the news as it comes.
It’s not, of course. To have the greatest chance of achieving your most important goals, your best bet is to have a well-considered strategic plan.
In this piece, we discuss the essential ingredient in a successful strategic plan: asset allocation. We start by explain its importance, and then discuss the key elements we consider in allocating assets in a portfolio.
Picking stocks or funds don’t matter much
Many investors start by selecting a stock they like, or an investment manager or fund.
The problem with this approach is that it rarely takes account of the investor’s objectives, time to invest or risk profile. So, while they may select a good stock of fund, it may not do what the investor needs their investment to do.
More importantly, selecting a particular stock or fund actually has little impact on a portfolio’s risk and return.
Instead, the research shows what matters most is an investor’s strategic asset allocation. This is the decision you make about how much you allocate to growth assets – like shares and property – versus defensive assets – like bonds and cash.
Around 90% of the return variation in a portfolio is explained by the asset mix. That leaves only 10% for any contribution (positive or negative) from timing markets or picking funds or stocks.
Determining the right asset allocation
To determine the right asset allocation for your portfolios, it’s helpful to clarify what you need your investment portfolio to do for you.
It’s helpful to consider the following important factors: your ability, your willingness and your need to take risk.
- The ability to take risk is determined both by your investment horizon and the stability of your human capital.
- The willingness to take risk (risk tolerance) is determined by how well you can handle the stresses caused by bear markets.
- And the need to take risk is determined both by your spending requirements (the higher they are, the greater the need) and the expected rate of return on your investment choices.
Your response to these factors may vary over time as your personal situation changes.
You may also have different views for different “buckets” of money you plan to invest.
For example, you may have one portfolio with a long-term horizon, like retirement (which could easily be invested for 30 years); and another investment portfolio with a medium time horizon, like creating a supplementary income stream to support you through a career transition in five years’ time.
In this case, it makes sense to create different asset allocations to match each bucket.
For portfolio one (compared with portfolio two), you may allocate more to growth assets – as these assets have higher expected returns which will help to protect and grow your real spending power over the long term. However, these growth assets bring with them higher risk – meaning capital losses may be greater in a market downturn.
Importantly, the decision of how much risk you can take – and the resulting asset allocation – needs to be driven by your goals, not the latest financial headlines.
Understanding the risk/return trade-off
In determining your strategic asset allocation, you need to understand the likely risk and return of different mixes of assets. The higher the growth assets in a portfolio, the higher the expected return – as compensation for bearing a higher risk.
We all have different preferences when it comes to the risk/return trade-off. Understanding your position is essential to creating a portfolio that you can live with over your investment time horizon.
A well-balanced asset allocation will also help you to diversify your portfolio.
The goal of diversification is not necessarily to boost performance—it won’t ensure gains or guarantee against losses. However, it can help to dampen portfolio losses.
The idea of diversifying is to invest in assets that are low or negatively correlated – that is, assets whose returns haven’t historically moved in the same direction to the same degree; and assets whose returns have moved in opposite directions.
A good example of this is the combination of equities and bonds – which have historically been excellent complements. Often, in periods where equities and property suffered some of their worst losses, bonds/fixed income havw delivered positive returns.
Which is why we include an exposure to bonds – to provide an offset to equity risk during periods of market stress, dampening portfolio losses and volatility.
Investing away from home
Diversification can be further enhanced by adding a mix of sub-asset class exposures to a portfolio.
One of the most important of these is the allocation between Australian markets and non-Australian.
Most investors, regardless of where they live, demonstrate a preference for investing in their home market – despite the evidence of risk/return benefits of global diversification.
Known as “home bias” this is the tendency for investors to hold a significant portfolio weight in domestic assets – often because they feel more comfortable with assets that are close to home, and names that they know.
Australian investors are no different, allocating approximately half of their equity allocation to domestic shares. However, this presents a significant risk in an investment portfolio.
First, because the Australian market is very small in global terms – representing just 2.7% of the global market.
Second, the concentration risk in the Australian market is very high – that is, the risk that losses are magnified by having a large portion of holdings in a particular asset class, industry sector or investment.
The Australian market (S&P/ASX300) has a very high concentration to the Financial and Materials sectors (banks and resources companies) – which make up more than 60% of the market.
This is nearly three times the share of these sectors in the global index (the MSCI World ex-Australia in AUD) – where Financials and Materials represent just 22% of the total market.
At the individual security level, concentration risk is even more apparent. The top 10 Australian stocks make up nearly half (47%) of the share market. Compare this with the global market where the top 10 stocks represent just 11% of the index.
By investing globally, the research suggests that over time investors can reduce portfolio risk without sacrificing market returns.
Avoiding over-exposure to property
Australian investors also need to be cautious in relation to investing in listed property.
Australians have traditionally preferred property investing – both via direct ownership and through listed property funds, known as Real Estate Investment Trusts (REITs).
The challenge again here is that investing in property in the Australian market introduces substantial concentration risks, of which most investors are unaware.
The first issue is that listed property is already included in the broader Australian share index (S&P/ASX 300 Accumulation Index) accounting for 8.6% of the total.
Similarly, when investing in global shares, investors will automatically gain exposure to listed property – as the MSCI World ex-Australia Index includes a 3% weight to REITs.
Second, the Australian listed property benchmark (the S&P/ASX300 A-REIT Index) is itself is heavily concentrated. It is dominated by a handful of names with just four firms making up well over half the index. This increases the idiosyncratic firm-specific risk in a portfolio.
Third, REITs offer limited diversification benefit compared to equities. This is because, according to Vanguard, REITs have maintained a correlation with the broader equities market over the past 26 years of about 0.6.
This is considerably higher than the correlations seen for defensive asset classes which are used to provide a buffer against equity downturns – like bonds with a correlation to equities of -0.10.
Finally, if we take a broader view of a household’s assets, Australian investors already have significant property holdings, with investment properties forming 43% of total personal investments outside of superannuation. So, additional property exposure in the form of REITS only adds to a household’s total exposure to property.
Given the concentrated exposures of Australian listed property, the lack of substantial diversification benefits, and most household’s existing property exposures, a dedicated allocation to listed property is unlikely to benefit most investors.
Achieving additional sub-asset class diversification
Investors can also achieve additional diversification for both equities and bonds by investing in a range of sub-asset classes.
The academic research shows that there are particular dimensions which offer higher expected returns than others.
In the share market, the dimensions are:
- Size – small companies versus large.
- Relative price – value stocks versus growth.
- Expected profitability – high profitability companies versus low.
In the bond market, there are two relevant dimensions:
- Term – which is the timeframe until a bond matures.
- Credit quality – which is the bond’s credit worthiness, or risk of default.
In the portfolios we create, we include exposures to all of these factors, as we know from historic performance that they can enhance returns over the long run.
The key message is that focusing on what’s happening in markets or trying to pick winning funds or securities, is unlikely to enhance, and may even diminish, portfolio returns.
Instead, we focus our efforts on what matters most – understanding our client’s goals, and then creating portfolios with well-balanced asset allocations to provide the greatest chance of achieving those goals.