Transcript: Top Tips On Asset Allocation

Published in Investing on 5 June 2009

This is a transcript of David Kuo's recent podcast with Antony Williams from Evolve.

You can download or listen to this podcast here.

 

David:

This is Money Talk, the investment podcast from the Motley Fool. I'm David Kuo, and as the philosophical seamstress once said to her young helper, "When life throws you scraps, make a quilt", and with many of our investments in tatters, who better to help us turn our scrappy portfolios into comfortable quilts, when the market is cold and unfriendly, than financial planner Antony Williams from Evolve. Welcome to the podcast, Antony.

Antony:

Good afternoon, David.

David:

And of course your website is www.evolvefp.com. So Antony, let us turn straight away to asset allocation, which is a subject which is very close to my heart, and I think close to a lot of our listeners' hearts as well. Can you explain to us, what exactly in simple terms is 'asset allocation'?

Antony:

That's a really good question, lots of people have different views on what actually asset allocation means, certainly we have a view, and it's primarily about mixing the asset that you hold in your portfolio together to change the risk and return profile of the portfolio, that's what it means.

David:

Are you a big fan of asset allocation?

Antony:

Absolutely, because it's pretty much a free lunch in terms of reducing risk, without necessarily reducing returns by the same amount. It's a fundamental part of portfolio management for private investors in particular, and private investors who are looking to create and maintain financial independence.

David:

But can I take this spanner and throw it into the works now, because many of our listeners will be familiar with Warren Buffet, and what Warren Buffet said about asset allocation, he said, "People only need wide diversification if they don't know what they're doing", so are you suggesting that a lot of people need to build this asset portfolio because they don't know what they're doing?

Antony:

Fundamentally yes, the fact is …

David:

Don't hold back!

Antony:

… that the vast majority of investors, whether they be private investors, experienced investors or inexperienced investors, do not know the future, and unless you know the future or you have some form of inside knowledge, which of course I'm sure most people realise is illegal, then it's almost impossible to see how it's going to be better to try to beat the market, rather than accept the view that the millions of people who are participating in markets are likely to be better than you as an individual. Now, there is a caveat to that, which is if you have "inside knowledge", it's your own business or you're in an unregulated environment, like the property market, it may be possible to generate additional returns on a consistent and predictable basis, but in listed markets it's very difficult to see evidence that suggests that anybody can do that, including even Mr Warren Buffet himself.

David:

So are you saying that asset allocation does work then?

Antony:

Absolutely, the primary reason for asset allocation is not about generating additional returns, the primary reason for asset class diversification and asset allocation is to reduce one particular risk, and that is the risk of volatility - that's what most people understand as risk, and it's not actually everything, there's a lot more to risk than just volatility, and perhaps we can talk about that later on, but the primary reason for asset class diversification is volatility control, and particularly where you're investing to build a portfolio that's going to provide for your retirement, build a portfolio that provides you with financial independence, volatility control is a really big part of the overall portfolio construction aims.

David:

But what about those people that came to see you prior to this massive recession that we're in at the moment, they will have used asset allocation in some way – now, did it work for them?

Antony:

To the extent that it can work, yes, the fact is if you want to get above the returns that you can achieve from cash in the bank or above inflation, you're going to need to accept some level of volatility risk probably, and probably some level of liquidity risk as well, i.e. accepting that you're not going to be able to get their money out necessarily immediately, like you can with an instant access account.

What asset class diversification does, and that's what really we mean by asset allocation, is gives you a mix of assets that will perform differently at different times. Now, there is an argument to say, well all assets have performed the same in recent months, they've all gone down; well actually, that's not the case - if you have portfolio that's constructed using both low volatility, low stock market correlation assets, with high volatility, high stock market correlation assets, then that diversification has reduced the losses that people have experienced in the past six and 12 months, and we can certainly evidence that.

David:

So how do you go about deciding what to actually allocate the assets to?

Antony:

Well, the first thing to do is for an investor to think about what actually they're trying to achieve from their money.

David:

But do people know? They just want to make more money, don't they?

Antony:

That certainly is superficially what many clients come to us and say initially, and our skill as a financial planner is to help people to work out what money really means to them, and I suppose …

David:

What does money mean to people?

Antony:

People have to ask themselves fundamentally this question – what is important about money?

David:

I know we started off with the philosophical seamstress, but now we're down to this philosophical question – people just want money so that they have something when they can no longer generate money.

Antony:

Actually if you translate, that means they want something that provides them with financial independence, they have enough money to be able to not work, they have their own independent source of income in some ways, but you don't have to have an investment portfolio to do that, you could take whatever money you've got and buy an annuity, if you chose to do so; most people probably wouldn't want to do that for various reasons, but it is possible.

So, I think we would strongly advise investors to focus less on the money, and focus more on life, and what money means to them in their life, and it's only really when you can put the money in the context of those overall lifetime goals, how much money you need to achieve financial independence, what things you want to do along the way, that you can make rational, intelligent decisions about your investment portfolio. If you simply search out returns for the sake of the buzz, for the sake of the gamble, for the sake of the fun, then you're invariably going to be disappointed, because the thrill of winning is only about half as good as the fear of when you do badly.

David:

But doesn't everybody need returns that are greater than inflation, because otherwise whatever pot you have is shrinking all the time?

Antony:

Absolutely, but if you're already x number of years old, let's assume 50 years old, and you've got a certain amount of money in your portfolio, if you do run that down and at age 100 you've got nothing, if you don't care whether your kids or anybody else gets the money – who cares? – all that really matters is that you have enough money to achieve all the things you want to do. Now, that assumes you don't mind leaving opportunity on the table, it assumes that you're going to have a static rate of inflation over a period of time and that you're not going to get periods of hyperinflation that undo all of your assumptions, so what we would certainly do with clients is, we would work through with them to understand what it is that's important about their money …

David:

But do people know?

Antony:

Without asking themselves the question, what's important to them about money, no; but there are certain techniques that we use with clients that are available freely on our website that help people to work out what's important about money to them.

David:

I'm getting interested now.

Antony:

Yeah, so you can go to the website, and we've got a little questionnaire effectively, which is, kindly, we're allowed to use by a gentleman by the name of George Kinder, who runs a life planning service in the United States, and it is a bit American, it's fair to say; when we see these sorts of touchy-feely American things that come out, sometimes we say, is that really for me over here in the UK, with our stiff upper lips? – but actually these three questions really help people to work out the most important things in their lives, only then that we can then construct a long-term strategy, what we call a 'lifetime cashflow plan', to work out how much money people actually need, how much money they need to achieve all their goals along the way, and be financially independent. Now, they might already have that much money, or they might not. If they've already got it, or they've got more, then clearly that would have a different impact on the type of portfolio that they should be using versus someone who doesn't yet have enough money, but has a very large amount of income, perhaps over the next 20 years, because they can take a different approach.

David:

But did you see this credit crisis coming, did you see this recession coming?

Antony:

No.

David:

So how did you position people's portfolios going into the recession then?

Antony:

We would take the view that we're always going to see these sorts of shocks, it might be this time the availability of credit that's caused it, which has been the case, or the time before it might be a plane crashing into a building in America, or tech stocks being overblown, and suddenly the asset price is falling, and that's making people feel poor, or the time before that, the housing market – it's always going to happen, again and again and again. The one thing we can be certain of is there will be another shock, just like this, could be worse, could be better – who knows? It will happen again.

David:

So how do you position your portfolio to avoid that then? Well, not to avoid the disaster, but for your portfolio to avoid being hit?

Antony:

No, I understand. There's no predictable way to be certain that you won't get any impact. What you can do is use the lesson of history, and it is the only lesson that we have, to look at which asset classes perform well in downturns, and which ones don't.

David:

Which ones do then?

Antony:

OK, broadly speaking the ones that perform well are assets which particularly institutional investors use as a flight to quality, so when they're really scared about balance sheet problems and they're selling off their equity exposure, selling off their property exposure, where do they go? Well, if you've got a few billion pounds, you can't go along to Barclays Bank and deposit it with them, even if they'd take it; what you do is you buy very short-dated, very high quality, probably government, or to some degree supranational debt instruments – that's what you do, you take your money out of risky assets and put them into short-dated, high quality assets.

David:

What, government gilts?

Antony:

Gilts, T-Bills, bonds issued by very large supranationals – those sorts of instruments.

David:

But are you worried by talk at the moment that maybe the UK Government may default on its gilts?

Antony:

It's always a chance, as it is with any government or any country, but it's pretty unlikely, and even if that were the case, the chances of it hitting the short-dated end as much as it might hit the longer dated end is less, so we're still very comfortable with short-dated instruments, and in any case, certainly for our clients, we don't just use gilts, we use a portfolio that is all major governments, all major countries, and most major supranationals, so we're talking about very high quality, but also highly diversified, so if any one of those institutions or countries does default on its debt, yes it'll have an impact on the portfolio, but it's certainly not going to be a disastrous one, we might be talking one or two percent of the overall.

David:

So you're not worried by talk that maybe some corporations could default on their debts as well then?

Antony:

Not when we have the level of diversification that we have in the portfolio of short-dated securities that use to dampen the volatility of the overall portfolio.

David:

So do you buy individual bonds, are you buying a big basket of bonds through some kind of exchange traded funds, or what?

Antony:

It's actually an institutionally managed short-dated bond fund that we use, which runs at about 0.25% annual management charge, and has no more than around one or two percent in each individual security, so it's very low risk.

David:

But bond funds aren't doing particularly well either, are they?

Antony:

Not the lower quality corporate debt funds, certainly they've been hit very hard, because they have very equity-like characteristics. We're not talking about equity-like bonds, we're talking about very high quality short-dated instruments, they're very different. And what we've seen through history is that, in really difficult times, there is a flight to quality, and the assets that do well are those very high quality instruments, so we've seen a significant positive return on those assets over the last 12 or so months, which helps to compensate not fully, but to some degree, with the fall in value of higher risk assets such as equities and property.

David:

So are you saying there is a perfect portfolio there?

Antony:

In the sense that there's a portfolio that will generate very good returns in all weathers – no; in the sense that there's a portfolio that gives you a good degree of volatility dampening or control, but whilst picking up a good proportion of the overall long-term returns that you might expect from participating in equity markets – yes, I am saying that, there is a way of achieving that. The key thing though, David, is that not to expect it to be delivering the highest possible returns, if you want the highest possible returns, we'll probably go down to the racecourse and put your money on a horse, not that I know anything about horse racing! – but you know, that gives you the highest possible returns, it also gives you a pretty good chance of complete loss. 

The type of portfolio that we would put together for a client, there's a very very small chance of complete loss, and more than likely not a particularly high chance of a very large loss, so in the last 12 or so months, we've seen our average portfolio fall in value by about 14%. That's more than I'd ideally like to lose, but it's a lot better than having put all your money in the stock market and lost 40, 50%, depending on which markets you're in.

David:

So why would anybody even need to come to you, I mean if all you're saying is, stick your money into government gilt, why would anybody need to come and see you?

Antony:

Well, I certainly am not saying they should put all their money into government gilts, what we would say is …

David:

I was overstating!

Antony:

…definitely! I think it depends on your age, is one factor in what your golden aspirations are, but certainly most people are going to need to think about not only the risk of volatility, not only the risk of liquidity, but also the risk of inflation – if you're 40 years old, then inflation is arguably the biggest risk that you face, by far greater risk than the stock market volatility that we've experienced in the last 12 months or so.

David:

So are these assets that you spoke about earlier, what assets are correlated in some way, so that if somebody was building a portfolio, to try and get some kind of negative correlation there, how would they go about doing that?

Antony:

Well, again we can only learn from history, and unfortunately some of those historical experiences haven't been proved to be the case in recent months.

David:

No they haven't.

Antony:

Certainly commodities which we were speaking about earlier on, the commodities have gone down in value pretty quickly, but we would argue that broadly speaking, that there is only four real asset classes, and that's for the purposes of portfolio management anyway, and that's cash, fixed interest, so not just gilts, but other fixed interest instruments, equities and property, and commodities, because they don't generate any income, you can't really invest in them as such, you trade them, and you can make short-term returns and you can make long-term returns, but they don't in themselves have the ability to generate profit, and therefore they're not an asset class in the same sense as the others. 

Hedge funds, some people would argue is an asset class, we would argue differently in that it's not an asset class, it's an investment style or a trading approach, not an asset class in itself, and precious metals, similar to commodities, they don't actually have any potential for producing profits themselves, so therefore they're not, in the same sense, an asset class to the other assets.

So we would concentrate on those four main asset classes, and what you can see is that, if you had a portfolio of 100% equities, over the very long term you'd get the highest possible return. If you had a portfolio of 100% cash, the most liquid, the most secure, you'd get the lowest return. Property and fixed interest are somewhere in between. What mixing those asset classes does is it gives you a lower level of volatility for any given degree of risk, and that can be factually proved, but that doesn't mean to say that there is always going to be a negative correlation, because there isn't.

David:

Do you buy into that rule of thumb, that says that you express your age as a percentage, and that should be the amount of your portfolio allocated to cash? – so somebody who is 20 years of age should have 20% of their portfolio in cash, a 30 year old should have 30%, so on and so forth, and by the time you're 100 years old you should have 100% of it in cash and nothing in any other assets?

Antony:

Assuming you're only interested in your lifetime, and you're not interested in passing any wealth to your children or to charity, I think there's a lot to be said for that basic philosophy, I think there are a few flaws in it, but it's getting on the right lines. I think I'd argue that, if you were young, actually your biggest asset is your future income stream, and therefore you could probably be even more aggressive, as long as you're comfortable with the level of volatility that's involved, but you can be more aggressive than having 20% in fixed interest, and 80% in equities; the flipside is, I think, if you were getting close to age 100, you might even be keen to get into an even lower risk position at around that time, because your time horizon is unfortunately forever shortening. The other factor is, I wouldn't necessarily say cash either, cash has not generated such good returns as fixed interest over the very long term, so you're better off probably suffering a liquidity risk with fixed interest investments, rather than cash.

David:

So are you saying there is a correlation between age and risk then?

Antony:

There certainly is, because what you're, I think, referring to there is volatility risk, and what we're thinking about is a combination of volatility, liquidity and inflation. As you get older, your level of exposure to inflation risk reduces, if you're only going to live for five years, inflation's not going to do a lot of harm to your investments or your wealth in five years, whereas if you've got 50 years to live, inflation is probably the biggest risk you face. Inflation has historically in the UK been relatively high, and certainly even a relatively small number of years of inflation can have dramatic results in terms of eroding the value of your wealth.

David:

So how often should people be, for want of a better word, tinkering with their portfolio? How often should they be doing that?

Antony:

There's two different approaches here, and certainly some investment advisors may have one approach, ours is perhaps different to theirs. There's basically two approaches, there's a tactical asset allocation approach and a strategic asset allocation approach. Our approach is very much strategic, we're focusing the asset allocation decisions on the clients', the investors' wealth, their time horizons for how old they are, as you've highlighted, and the level of risk tolerance they're willing to accept, and then broadly speaking we're going to keep that asset allocation the same, forever.

Now, forever is a very very long while, we will need to take some views on some strategic changes, but broadly speaking, what we're not going to be doing is saying well, we like the US at the moment, so we're going to have more there, or we like Japan, we're going to have more there, because that's just making a market timing call, we don't do that. What we do is, however, is rebalance the portfolio back to our pre-agreed strategy, so we decide on a strategic asset allocation, so for simplicity let's just say it was 60% equities, 40% bonds, and let's say the stock market does very well over the next few years, we would want to rebalance the equity portion back to the 60% that we originally allocated, so that we don't allow the portfolio to end up being more risky than it was originally. Similarly, if stock markets fall, as they have done, that would be a trigger to rebalance the portfolio back to having a lower weighting in bonds, so we go back to the 60:40 strategy.

David:

So you don't believe in running your winners then?

Antony:

No.

David:

That's not your job?

Antony:

No, the reason being is, because what we're looking to do for clients is, where we make gains on an asset class, so going back to the first example of equities doing well, we want to actually basically lock in some of those gains, get us back to the level of risk that we originally wanted to take, because the danger with all of us, whether we're professional advisors or private investors, is that we get carried away, and we let emotion override logic – "It's going really well, so I want more of that asset class. Equity's the way to be, because the returns have been 10% per annum", - and guess what, at some point they won't be 10% plus per annum, they're going to be 20 or 30% negative in one year, so we want to be locking in some of those returns.

Similarly, our emotional approach is that when things are doing really badly, it's time to get out, and now's the time to sell, and therefore we sell the equities and buy the low risk assets, whether it's cash or bonds, and that's almost over every single time period that you look at, the worst thing you can possibly do. A recent study by Lucas Schneider at Dimensional Fund advised, prior to the credit crunch, prior to the recent downturn, but the average equity market return over a roughly 20 year period was 9.5%, the average investor in an actively managed investment fund got 7.5%, still not too bad, but they've lost 2.5% of that return, but the actual return that people achieved on a money weighted basis, ie, taking into account when they invested, rather than just the fund return, was actually down at about 5.5%, so the timing calls, where people have said, well I'm not investing now, because now's the wrong time to invest, and actually I want more of that now, that's what's destroyed an extra 2% of return, so we want to try and remove that risk, and simply rebalance the portfolio back to a strategic asset allocation on a rules basis, taking out all emotion.

David:

So when do you do that then? Do you do it once a year, twice a year?

Antony:

Depending on the size of an investor's portfolio, it could be more regularly, but certainly once a year. The key trigger is how far out of balance we are, so in a very extreme period, like we've seen in the past year or so, that rebalancing process could happen a little more regularly, because the portfolio will have become significantly more out of balance more quickly. In a more benign period, where we are getting returns that are more "average", then it can be less regularly, but broadly speaking it's based on a tolerance basis, so if you're going 10% out of your model portfolio, out of your target asset allocation, that's when we rebalance.

David:

So do you allow tax to be a consideration as well?

Antony:

Certainly for clients where a significant proportion of their wealth is in a taxable portfolio, certainly. In many cases, however, our clients have built up various large parts of their portfolio in ISAs or PEPs, as they were, and indeed in their pension, and therefore in those environments you don't need to worry about tax.

David:

OK, now one final question before we end, and this concerns wealthy people. We've heard recently that some of the world's richest people have seen the value of their wealth fall by about 20% in some cases. Now, can rich people afford to take more risk with their portfolio?

Antony:

Well, certainly if they have enough wealth such that their total capital is easily enough to provide for all of their financial goals and needs, their expenditure over the coming years, then arguably they can afford to take more risks, so they could say, well I only need £5 million to cover all of my future expenditure, I can take the other however many million or billion and do something else with it, so certainly that is true; however on the flipside, wealthy people do not need to take as much risk, as they already have enough money, so therefore why take it? Why take the risk of losing all of that when you could just accept a very modest return, perhaps even a negative return in real terms.

David:

Can you explain that?

Antony:

Yes, I mean certainly if you have a return of, let's just say, 3% per annum, you could, with a reasonable degree of certainty, get that sort of return, but actually inflation is currently running at around about the same level, it depends on your measure, and it could in future of course be higher than that, so your real return ends up being lower than your nominal return, and a wealthy person can probably afford to have an element of real depreciation in the value of their wealth over a 20, 30, 40, 50 year period even, and still have enough. Someone who is just on the cusp of having enough money, so maybe they need £50,000 a year and they've got a million pounds of investments, they're going to have to be very careful about inflation, because it will make it much more difficult to achieve the real return that you need in order to achieve and maintain financial independence.

David:

OK, I said that was my final question, I actually have a final final question, and this is one that I'm actually quite intrigued about, which is, when do you see this recession ending?

Antony:

Well if I knew that, I probably wouldn't be sitting here talking to you, David, because I'd probably be on a very nice beach somewhere drinking Pina Coladas. The answer is, I don't know, to some degree I don't care, and the reason that I don't care is because I think if we get into that game of trying to predict that, what we're really saying is, we know something that other people don't. I can have a view, and I can have a belief, but it's not fact.

What I can, however, say is that historically equity markets in particular, of all financial markets, have tended to be predictive, so they're not looking at what's happening to company profits today, they're looking at what's going to happen to company profits in 12, 24, 36 months' time, and therefore we could certainly take the view that, if equity markets start getting more confident and we start getting good returns from equities, then that's a predictor to the economy turning around, but it won't happen immediately, it'll happen after the stock market turns, and that's the point about market timing is, you wait until the economies rebound, and the equity market will have already done its bit, you've missed out on some of the best days of returns.

So in direct answer to your question, I don't know; however, if I were a betting man, I would say we're going to see elements of the economy returning to at least a more sort of positive sentiment, if nothing else, towards the end of the year, towards the end of 2009, but the real impact on people isn't really going to be seen until the latter part of this year and through into next year, because that's when the unemployment situation is going to become more and more difficult, there's going to be more and more people unemployed, and that's when it's going to feel like the recession is at its worst, in many respects. From a financial markets perspective, I think we'll be seeing some more positive signs significantly earlier than that; however, that's primarily just because of the amount of capital that's been injected into capital markets over the past few months by central banks.

David:

But that could be very inflationary as well?

Antony:

You're absolutely right.

David:

Which therefore means that people need to be aware of the inflation out there, which means that you have to invest in real assets, assets that appreciate ahead of inflation?

Antony:

Well certainly even if you, whether you should or shouldn't be investing in real assets, what you should be doing is looking at your overall financial strategy, and seeing how much inflation your finances can tolerate, so modelling the impact of high levels of inflation – that's what we would do for our investors.

David:

Now, I would love to carry on, but we have run out of time. If you have a comment about today's show, you can post it the MoneyTalk blog, which you can find at www.fool.co.uk/podcast. You can also email me at moneytalk@fool.co.uk, but before I go Antony, I always end each podcast with a quote, and I always try and find a quote that I think will sum up what this talk was all about, and today's quote comes from a sociologist called Abraham Maslow, he said: "It is tempting, if your only tool is a hammer, to treat everything as if it were a nail" - but we all know that you undo a screw with the blade of a knife, don't we?

Antony:

Absolutely!

David:

And we do in our household, anyway! So, thank you very much for coming in today, Antony, that was Antony Williams from Evolve FP.

 

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