5 Asset Allocation Lessons

Published in Investing Strategy on 28 October 2009

Here are 5 things to remember when deciding on your asset allocation.

In my previous five articles on asset allocation I've been broadly positive on the approach, basically because I believe in it and it's served me well over the years. However, in that time I have encountered several issues (maybe even problems), that need to be acknowledged, assessed and addressed. In my experience there are at least five lessons that need learning.

1. No one gets rewarded for liquidity risk

A fundamental tenet of any asset allocation strategy is selecting an appropriate mix of assets and basing at least part of that decision on lack of correlation (in other words some assets rise at the same time as other assets fall in value). 

In recent years that has meant the increasing popularity of assets such as real estate, private equity and 'alternative investments'. The problem is that in a genuine financial crisis some of these assets become very illiquid. In other words, you can't sell them (quickly).

You are therefore not only taking on investment risk but also liquidity risk, and there are no rewards for liquidity risk -- only downside. Investors who had large positions in private equity, hedge funds and commercial property last year not only suffered large price declines but were also 'locked in' to their investments. This was a first for many investors, especially holders of some property unit trusts.

2. Even long-term investors should think about the short term

Many of the authoritative experts on asset allocation do not think of cash (deposit) as an asset. I completely disagree. Cash is a damn fine asset and most useful in torrid times. 

At present you can get 5% gross for five-year fixed interest bank and building society deposits. That's a very good premium to equivalent gilts and yet they have the same state-backed guarantee of safety (generally up to £50,000 per person per deposit account). With inflation looking benign to non-existent for at least two or three of those years, that's a stonker of a deal. The best paying instant access accounts are still paying 3% in real terms (i.e. over and above inflation.)

Why should a long term investor think short term? Simply because the unexpected does happen and a large amount of cash may need to be realised.

3. Avoid 'style drift'

OK, so you've decided on your ideal asset allocation and you've gone for some well managed income, value and growth funds for the equity portion of your portfolio. Can you just sit back and relax now? No! Not if you're in managed funds.

Some managers have a nasty habit of modifying or changing the 'style' of their funds to fit with their latest views of the market. So we find income managers using a 'bar-bell' approach of holding a portfolio of income stocks together with a good few growth share to provide capital gains. But you don't want growth stocks (or if you do they reside in their own section of your portfolio.)

The purest way to gain consistent exposure to an asset class is through the appropriate low-cost index tracker or exchange traded fund. You want value as part of your portfolio mix? Buy a value ETF through a low-cost platform, such as The Motley Fool Share Dealing service.

4. Obey your pain threshold

In one of my earlier articles I pointed out that a popular asset allocation for a 'balanced growth' investor is a 60% equity, 40% bond portfolio. Whatever your time horizon take such advice with a pinch of salt. Instead focus on your pain threshold. 

Are scared stiff of losing 50% of your money over one year? Don't go anywhere near those equity weightings. You may not get rich holding cash and index-linked bonds but it may help you sleep at night and avoid ulcers.

Never forget that high(ish) equity weightings have been derived from the long-term historic performance of that asset class. For many of us in the English speaking world, that's been based on about 100 years of US and UK stock market returns. Unfortunately most other nations have been plagued by political upheaval and financial crises, and endured low or non-existent equity returns. The median stock market real return over a century is about 1.5% according to some researchers. That past maybe our future.

5. Don't get greedy when you've got enough

Before I retired, one of the few financial advisers I admire asked me this question; "how much annual income do you want?" Quick as a flash I replied, "as much as possible". Wrong answer, he said "think... how much do I need?" Confuse the two and you will forever be invested in too risky an asset mix.

More from Tudor on asset allocation:

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UncleEbenezer 28 Oct 2009 , 11:13am

"How much do I need" is exactly the wrong question in the modern world (at least in Europe). Because the answer is either [b]nothing at all[/b] (European countries have state-backed safety nets for those with nothing) or [b]how long is a piece of string?[/b] (who can tell what the future holds, especially for those of us in a "bulge" generation for whom there will not be enough resources to go round in our declining years).

alarmbells 28 Oct 2009 , 4:29pm

Hmmm. So what the dickens is the right question?

namron101 29 Oct 2009 , 9:04am

"No one gets rewarded for liquidity risk" - really?

People like David Swensen at Yale, who have looked very hard at this, have concluded the exact opposite - that because most investors do worry a lot about liquidity, they accept returns that are on average much lower on liquid than on illiquid assets.

The stellar long run investment records of the Yale and Harvard endowments reflect this. They have put a lot into a variety of illiquid assets, have stumbled occasionally (as in 2008), but achieve far better long run returns than most other investors.

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