The Basic Building Block Of Investment Performance

Published in Investing Strategy on 12 October 2009

Your asset allocation drives your investment performance.

What is the major determinant of your investment performance? Your skill at market timing? Or perhaps your ability to pick a ten bagger? 

Nope, it's how you allocate your funds between various assets. Although asset allocation has been a hot investment topic for over 50 years, its enduring relevance was highlighted by last year's 'perfect storm' when virtually no portfolio escaped with less than double digit losses.

Optimise risk and returns

Most folks understand the concept of return only too well: the gain (or for the last few years) loss generated by an investment over any given time period. Easy.

When asked about risk most people would articulate a definition like "the probability, or possibility, of a loss". Well I guess that's fair enough, but it's only half the story. In investment terms risk is more than that. It's the spread, or volatility, of returns around an average. Now, many of you will be saying bring on the volatility -- as long as it's on the upside. The problem is volatility always works both ways.

To understand how risk (volatility) can damage wealth let's take a look at two different portfolios over a two-year period. Portfolio A invests in a mix of assets that increases in value by 5% each year. Portfolio B invests in a mix of assets that increases by 20% in year one and decreases by 10% in year two.

At first glance, we can see that these portfolios have the same average (mean) return of 5% a year. But let's take a look at the investment result.

Portfolio A 

(1+5%) * (1+5%) -1 = 10.25% gain

Portfolio B

(1+20%) * (1-10%) -1 = 8% gain

So portfolio A achieves a better return, because it has a lower volatility than portfolio B. It's also a function of the way percentages work. The 10% loss in year 2 comes after the 20% gain in year 1. It therefore costs you 12% of your original capital. 

To my mind, the lesson is 'volatility is not your friend'. So, how does an investor reduce the volatility profile of an investment portfolio?

Select non-correlated assets

In any given set of market conditions some assets will rise and others fall. As an investor you cannot avoid this risk, but you can manage and control it. You grab control by selecting a mix of assets that move in different directions. 

Using figures from Seven Investment Management, the table below shows various asset class behaviour for 2008. 

Asset2008 Return
Global government bonds51%
Index linkers4%
Corporate bonds-8%
UK property-23%
UK equity-30%

So while an investor fully invested in UK equities would have lost 30% of their portfolio in 2008, someone who had an asset allocation of 50% UK equity and 50% global government bonds would have made a return of 10.5%.

Of course, that example is based on hindsight, but the principle is to find assets that move in opposite directions (negative correlation). Bloomberg estimated the five-year correlations of asset classes to US equities as follows (where 1 would be perfect positive correlation and -1 would indicate perfect negative correlation).

Developed world shares0.98
Hedge funds0.95
Small cap shares0.93
Real estate0.87
Corporate bonds0.72
US Government bonds-0.17

Adjusting for your risk profile

The astute, more aggressive and probably younger investor would have taken a brief look at my two portfolios earlier in this article and thought: "I don't mind portfolio B -- as long as in the future that asset mix has more positive 20% years than negative 10% years". Correct. Your ideal asset allocation will depend on your time horizon and your risk tolerance.

For those investors with lengthy time horizons stretching to decades having an asset allocation skewed toward high risk, high reward investments is perfectly sensible and would include large portions of private equity, smaller companies and emerging markets.

For those with specific time goals or short horizons, a more balanced approach is required. As an indication of sensible asset allocations and time scales Vanguard recommends a 90% equity/10% bonds allocation for a growth-oriented investor with a 25 year horizon. For someone who has just retired they recommend 50% equities/50% bonds (coincidentally the mix I highlighted as returning 10% in the dark days of 2008). Vanguard also shows risk and reward returns for a variety of asset allocations on its excellent site.

In subsequent articles over the next few weeks, I'll be writing about specific types of asset allocation strategies and how to fine tune them.

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datacast 12 Oct 2009 , 10:02am

Portfolio A

(1+5%) * (1+5%) -1 = 10.25% gain

Portfolio B

(1+20%) * (1-10%) -1 = 8% gain

So portfolio A achieves a better return, because it has a lower volatility than portfolio B.

NO!! - Portfolio A achieves a better return due to the compound of the percentages being larger.

A better example would be

Portfolio B

(1+20%) * (1-7%) - 1 = 11.6% gain

This then poses a real question - Do you accept the increase in volatility for the potential increase in gain? The answer of course depends on your time horizon and minimum return requirents year to year.

gordonbanks42 13 Oct 2009 , 6:50pm

@datacast - thanks, you have got to the point.

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