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Your first step to a first-class investment strategy

Asset allocation – the decision over how much to invest in equities, bonds, property or cash – is crucial. Mike Deverell of Equilibrium Asset Management provides a helping hand.

 
Your first step to a first-class investment strategy

The cornerstone of any investment strategy is the asset allocation.

The decision over how much to invest in equities, bonds, property or cash is crucial. Academics tell us this decision makes up around 90% of the variance of your returns.

However, making asset allocation decisions is not easy.

Diversification

Unless you are an investment genius or extremely lucky, you should diversify your portfolio across multiple asset classes.

The first determinant of asset allocation is risk. How much risk can you tolerate emotionally? How much risk can you afford to take? What return do you need to achieve your goals?

Before investing, decide how much you need to keep in cash to cover emergencies, perhaps three months income or 10% of your portfolio. If you need access to cash within the next two years, it is unlikely to be a good idea to invest it.

You should also keep a substantial chunk of your portfolio in low to medium risk assets like property and fixed interest, especially if you are taking income. A good rule of thumb is 10 years income, so if you are taking 5% out of your portfolio a year, keep 50% in low to medium risk assets.

Once these criteria are satisfied, you can then invest the balance in equities. As a rule of thumb, keep equity investment below 75% even if you have a very high risk tolerance. This allows you to rebalance when markets fall, topping up holdings to benefit from a recovery.

Strategic vs Tactical asset allocation

The above process is a good way to work out your strategic asset allocation. This is where you would invest long term if you had no opinions on the market and were happy to leave your portfolio for 10 years without management.

However, most people prefer to actively manage their asset allocation, adapting it to market conditions. This is known as 'tactical' asset allocation.

Relative Value

To determine your tactical asset mix you should consider the relative value of each asset class. The premium above cash or gilts, for example, is one way of deciding if the asset class looks cheap or expensive.

Here are some basic ways of looking at the major asset classes. Note that we are ignoring property in this article because data is not easily available to the non-professional investor. At Equilibrium, we are not currently holding property in our portfolios.

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34 comments so far. Why not have your say?

HR Man

Jan 04, 2013 at 09:07

A couple of observations to make here:

a) Mike Deverell's article about diversification consists of investing your money in just two assets - Equities and Fixed Income, when diversification is about investing your assets across the investment classes not just two of them - Property, Commodities, Infrastructure- you need to have your money in places that will react differently to circumstances

b) Mike argues that it is difficult for private investors to invest in property because there is little data around -but this is not so. For Commercial Property there are reams and reams of data on this market - and how funds are performing and what is providing the best yield

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Anonymous 1 needed this 'off the record'

Jan 04, 2013 at 10:15

Agree with HR Man's first point. Diversification should mean diversification of risk. If you just invest in equities and fixed income then you're not really doing this.

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Mike Deverell

Jan 04, 2013 at 11:06

Hi HR Man - thanks for the feedback.

I also mentioned cash as well as equity and fixed interest! Yes, I agree alternatives have a place in a portfolio, including absolute return strategies. Unfortunately, we need to simplify things for a short article like this one.

However, most investors will find it difficult to determine value in commodities and infrastructure. Many funds that label themselves as such are in fact highly cyclical equity funds which don't really diversify your portfolio. They are highly correlated with the economic outlook.

Regarding commercial property, in order to properly assess you need to look at rental yields, vacancy rates, rental growth and a myriad of other issues. Very little of this is freely available and it costs around £10k pa for an IPD subscription!

We are currently avoiding property as returns are likely to be little more than cash in our opinion, and therefore not worth the risk.

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Keith Cobby

Jan 04, 2013 at 11:31

I like F & C Commercial Property Trust Ltd and TR Property Investment Trust.

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HR Man

Jan 04, 2013 at 12:01

Hi Mike - yes I appreciate that you have cash in the mix as well and there is always the need to keep things simple but I would still argue that if you are serious about reducing your risk and increasing your returns then you do need to include the other asset classes.

The case for example for Gold as 'insurance' for bad times is pretty well known (ditto for Gilts) and although I would readily accept that there are a number of funds parading as infrastructure vehicles when in fact they just invest in companies that as part of their business run road and schools projects, if as a private investor you do your research you will find funds such as HICL where there is a pretty much guaranteed income stream of around 6% plus some capital growth.

On Commercial Property I would agree with Keith Cobby that FCPT (5.5% yield) is a very good fun but TR Property is like some infrastructure funds really a equity bet as it has little money invested in direct property. I would dispute that to invest in property you need to go to the lengths of an IPD subscription though!- access to Trustnet and other sites can easily give you returns in the commercial property sector (or you can read Estates Gazette from your local library) and you can see which funds invest in which kind of tenancies and peruse say the FCPT Annual Report you will see vacancy rates etc.

My overall view is that as a private investor you just need to invest across the spectrum of classes to get decent returns with a strategy that allows you to sleep at night- for example I have 50% in FI, 20% in Equities, 10% in Commercial Property, 10% in Infrastructure,and 5% in Gold and Cash each and that is given me a 9% return over the last year- which is what I would expect a balanced, diversified portfolio to hit. I don't want to go for a 15-20% return by betting on small companies or emerging markets but just want to see my money grow at an impressive (cash +3 or 4%+) rate and with a sensible well thought out portfolio I believe it can be down via managed funds...

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Anonymous 1 needed this 'off the record'

Jan 04, 2013 at 12:17

The case for gold as insurance is pretty well documented but I wouldn't take that as fact. As someone who trades commodities for a living, I personally think that using a single volatile commodity in a portfolio is pointless. To me, you can make a fantastic-sounding argument for why Gold could go to $10,000 but I would be equally un-surprised with gold at $300 again

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HR Man

Jan 04, 2013 at 12:29

But the argument to hold Gold in a portfolio is really the same as for Gilts in that when you look at major periods of instability -the so called 'Black Swan' events - the asset class has helped protect portfolios in a way that equities for example cannot. I would always argue that you should have some Gold (say 5%) in your investments to give you some protection and it is a good counterweight to some of the more stable assets such as Corporate Bonds, Infrastructure and commercial property funds

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Keith Cobby

Jan 04, 2013 at 12:29

I agree with Anonymous re gold. It fails one of my investing rules because it doesn't produce any income.

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Anonymous 1 needed this 'off the record'

Jan 04, 2013 at 12:48

That's an interesting point you make HR Man as it seems to be the reason I can think of why people think a holding in Gold is so valuable, aside from the inflation protection. I'm sorry to say though that a quick look at a chart of Gold versus any major stock index shows that in most black swan events / crashes, gold has actually done very little. The point of a hedge or an un-correlated portfolio instrument is to produce good returns when your other investments suffer. Alas, there is no such thing as the perfect hedge but as the most recent example, in the most recent peak-to-trough drawdown of equities (2007-2008) Gold lost about $300 so it would have also been a drag on the portfolio

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Anonymous 1 needed this 'off the record'

Jan 04, 2013 at 13:00

And before anyone says it, Gold versus the US10yr tells a similar story

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HR Man

Jan 04, 2013 at 13:01

I agree that income is very important but just because Gold does not provide a dividend or coupon does not mean that it is not a asset worth holding. For example take TR Property as a fund - yes it provides useful income but between 2007-2009 it lost 60% of its value (its share price went as low as £1.02 )and a yield of say 4% a year is fine but it would still leave you nursing up to a 50% loss on your investment.

Over the same period, Gold increased by just over 55% -an almost identical inverse to property securities which I would argue shows the advantage of holding asset classes that respond in different ways.

In short my view is that whilst income is very useful it means little if you have substantial capital losses!

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HR Man

Jan 04, 2013 at 13:32

Anon 1 -I disagree - if you look at how Gold reacted from 2007-2009 you will see that it went from $695 (Jan 07) to $972 (Jan 2009)- a 40% increase, whilst over the same period the FTSE went from 6310 (Jan 07) to 4434 (Jan 09) - a decrease of 30%- this is how you would expect an asset class like Gold to perform- no surprises! I agree that there is no 'perfect hedge' but what you do have is a combination of historical trends that when trouble strikes people have retrenched into the older refuges of what they think hold the ultimate value which is the oldest currency and Gilts where governments will not go bankrupt

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Keith Cobby

Jan 04, 2013 at 14:02

The point about TR Property is that it depends on your starting point/purchase date.

My strategy is basically to buy investment trusts/companies only that generate dividends and hold for the very long term rolling them up (the 'snowball'). I consider holding them indefinitely and only make the occasional sale as I have never been confident of my trading abilities. My main concern is that they provide a sustainable and increasing dividend, and if this is the case the capital values will take care of themselves. Obviously need to ensure that you are not converting capital into income.

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Anonymous 1 needed this 'off the record'

Jan 04, 2013 at 14:08

It's easy to find specific periods in the past with the benefit of hindsight and say "this was up but that was down therefore it's an excellent hedge" but what you are missing in your example is that for the significant part of the crash in 2008, gold also crashed at the same time. The fact that it then rallied when equities didn't do much, doesn't actually tell you anything useful. The price of...I dunno...tractors has probably gone up since 2008 but does that mean it's a good hedge to equities? Well only if it had a history of going up significantly when equities suffer.

I am not disagreeing that Gold has different return characteristics to equities but I disagree entirely that it's an excellent hedge for a portfolio. If you go back to the previous crash when the tech bubble burst then gold didn't really go much and then further than that to black Monday in 1987, Gold also declined significantly at the same time.

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Malcolm Priaulx

Jan 04, 2013 at 15:09

I think gold will go higher but not until the second half of 2013. In the meantime I keep a toe in the water by holding Gamco Global Gold Natural Resources & Income Trust (NYSE:GGN) and earn a useful 10.5% yield which is paid monthly.

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Anonymous 1 needed this 'off the record'

Jan 04, 2013 at 15:19

I would like to borrow your crystal ball some time Malcolm, do you rent it out?

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Malcolm Priaulx

Jan 04, 2013 at 17:41

I have been lucky with gold. Rode it almost to the top and then shorted it so I made a good profit in both directions. I have a floor at $1550 for gold. Gold will really start moving up again when the US bond market starts to fail and all that money rushes into equities and commodities including gold.

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HR Man

Jan 04, 2013 at 17:54

Anon 1 - However the figures I produced were for the relevant calendar years rather than selecting them to make a point and whilst Gold did suffer a serious reverse in 2008 the point is that investors saw it as the place to run to. I think it went as low as $720 in October 08 but within a month it had risen to $820 and then $860 a month later (up 19%) whilst over the same period the FTSE dived a further 13%.

You say that the fact that Gold rallied and Equities did not does not tell you anything useful but I would argue the contrary i.e. that it demonstrates that when the proverbial hits the fan, people dive into safe assets such as Gold. Look at 29/32 & 73/74 -Gold was up 30% for the latter when equities lost around half their value.

You mention 1987 but on the day itself whilst the Dow was down 22% Gold was actually 2% up to a record high that year which again supports the contention that people turn to the metal when things get bad..

History shows that when equities are in significant trouble that Gold as the oldest currency becomes a valued property to own - that is shown time and time again. This is not mere coincidence,

I maintain that as Gold has different properties, it responds differently to economic and other news, and its history that to have some percentage of your wealth in the metal makes great sense and will help to protect your portfolio .

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Anonymous 1 needed this 'off the record'

Jan 04, 2013 at 18:02

Well we are both entitled to our opinions, we each have our own rationale and I suppose only time will tell. Even if Gold was up 2% (on the year not the day) when the Dow was down 22%, your 5% in gold would have given you 20bps protection. If you look at Gold's average annual return versus it's worst decline (well over 60-70% if I remember rightly) then a 5% holding is only worthwhile if you believe you can time your entry into Gold....and we should all be aware of the probability of getting that correct.

I am more interested in what happens if / when gold hits Malcom's $1550 "floor"!

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gggggg hjhjkl;'

Jan 04, 2013 at 18:18

From what I can see on most discussion boards gold is not a hedge against inflation or anything else. It appears more to be a religion.

To argue logically/rationally against a religion is nigh on impossible as can easily be seen from the aforesaid discussion boards.

I personally have never held it, being happy with the results of holding equities, fixed interest, commercial property, commodities and cash plus a little bit of dollar and euro investment risk.

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Anthony O' Grady

Jan 04, 2013 at 21:34

The money printing environment which we are currently in is perfect for gold. However the real one to watch is silver. Currently at 30 dollars it may go lower but I'm going to give a chunk of cash 3 years and see what happens.

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HR Man

Jan 05, 2013 at 00:18

Just to say that in 1987 Gold went up 2% on Black Monday (19th October) itself (not on the year) showing the non-correlation with equities and I think that is a safety net worth having. I appreciate that people may not buy into the Gold argument but I do think it is an important element of a balanced portfolio as much as say commercial property or infrastructure- in short I do think you need your money apportioned across the asset classes and adjusted for your financial profile and risk/needs

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Income Investor

Jan 06, 2013 at 09:20

Leaving aside gold, which as an Income Investor I don't hold, I have observed that even within the major asset groups of equities and fixed-income there are so many sub-categories that there is plenty of scope to diversification. My own high-yield mix of the two has given a 33% total return in 2012 - much more than any of the market benchmarks.

As for income trusts, be sure to look at how much of your income they are consuming - and of course, how much of the dividend is fuelled by debt or your own capital!

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HR Man

Jan 06, 2013 at 12:24

Very good analysis Income Investor -I too have found that it is not just balancing your portfolio between assets but also within them that can be key. For example within the fixed income arena I have 50% in investment grade bonds (up 12% over the last year), 25% in High Yield (+19%) and 25% in Gilts (up 1%) you can get an excellent 'blend' which got me around 11%- not bad when non ISA Cash is sitting at 2% at best!

And on equities although the average equity income UT is up 14%, the IT High Income funds are up 27% with the almost identical volatility of around 10% for the year.

But I think you need to keep an eye on risk via volatility ratings- High Income funds have outperformed High Yield funds by 40% but with 100% more volatility although you do need to look at the bigger picture too. Gilts are now as volatile (4% per annum) as investment grade bonds yet one delivered a 12% return whilst the other was barely in positive terriority, but there is major income out there to be had if you mix and blend it well enough

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Anonymous 1 needed this 'off the record'

Jan 06, 2013 at 15:33

I am so bored of people, particularly on Citywire forums, banging on about what their portfolio returned in a short time frame when it's actually somewhat arbitrary. It tells me that they are all focusing on the outcome rather than the process. I could have bought a leveraged ETF on a major stock index and made decent double digit gains every year since 2008.....does that mean it's a repeatable, robust strategy? No

Fair enough if you did it with a strategy that you feel will last the test of time but otherwise please save your boring stories for cocktail parties.

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HR Man

Jan 06, 2013 at 15:51

But Anon - are you saying that you should instead invest but not measure any kind of outcome? I think 12 months is a decent period to review how your investments have done partly because any serious investor does need to to look at their annual returns to decide if their portfolios have moved away from their balanced strategy and re-balance.

Also, remember the golden mantra Anon "You can't manage what you can't measure"!

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Anonymous 1 needed this 'off the record'

Jan 06, 2013 at 19:34

Firstly it seems that the overwhelming majority of people commenting on here have portfolios that have nearly all their risk in beta strategies. Given that there are two ways to make money in the market; Alpha and Beta, I would say that most do not diversify their risk appropriately.

It is obviously logical to review your investment performance periodically however the last 12 months are no real test for a portfolio that is primarily beta-dependent as the market was broadly up so your portfolio should be up as well. I would be far more interested in how people performed in years such as 2008, as that is the real test of the "process" and how robust a strategy is in the long term.

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HR Man

Jan 06, 2013 at 21:58

I don't know about Alpha and Beta but I do know that history shows that to have a portfolio spread across the asset classes gives your investments the best possible chance of limiting reversals and of higher returns.

If you follow these kind of strategies back through to the 1500s or so evidence supports that view - especially in times of trouble whether that is something like the Depression, the South Seas Bubble, the Tulips scam or whatever.

You obviously need to adjust your allocation strategy to take account of your target return and the risk (losses) you are prepared to accept but I have monitored my strategy since I started to invest back in the early 1990's and it holds up fine- limiting major reversals in the market and allowing for very decent returns in the good times.

And a lot of it is about something that has rarely changed- the psychology of investors in the good and bad times- balance out your investments and you should have some decent protection.

For example in 2008 whilst the market was down by around 30%, the attribution of funds in Gilts and Infrastructure in my portfolio paid off as they were up 13% and 5% respectively with Corporate Bonds losing just around 2%. As I had around 50% invested in fixed income it meant that I had some very good protection to avoid the ravages of the financial meltdown. It is rare that all asset classes go down the shoot and you are really just hedging your bets by not putting all your eggs in one basket....

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Anonymous 1 needed this 'off the record'

Jan 06, 2013 at 22:34

Beta = hold assets. Alpha = Make "bets" in order to try and generate excess return. If you are just a beta holder then you are mercy to the market hence why true diversification requires risk to be divided into both.

You're missing my point, no-one sensible would argue against diversification. My point is that many people think they are diversified when they aren't! There is a little more to it than putting your eggs into different baskets. It essentially comes down to correlation. If you want to reduce your risk, it is a mathematical fact that you want to find as many un-correlated return streams as possible. As Ray Dalio puts it, he's found that 15 un-correlated return streams is the perfect number - any more than that and you only reduce your risk by a small percentage. But at 15, you reduce your risk by about 80%.

The unfortunate fact however is that correlation among major asset classes changes and has been steadily rising every decade so anyone who says "I diversify my equity positions geographically" or "I have 60/40 in equities and bonds" or "I also have money in property" is making the mistake of assuming they are diversified when they aren't. Consider this, the correlation between real estate and equities is 0.57 since 1990 but since 2011 is 0.95. Hell, the correlation between soybeans and soyabean meal is lower than the correlation between the S&P and the Dow.

Further to this, I would also add that correlation can spike dramatically when you least want it to between major assets, just as it did in 2008.

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HR Man

Jan 07, 2013 at 11:34

Anon 1 - I do realise and am a great advocate of diversifying investments into non-correlated assets which is why for instance I always ensure that my commercial portfolio holdings are in direct property not a property securities fund and that my infrastructure holdings are in PFI/PPP projects direct and not with equities that just happen to be a PFI/PPP contractor , as you need your money spread into assets that react differently.

However I would take issue with your argument that correlation between assets spikes dramatically because in practice rather than academic theory, that does not seem to happen.

Again, take 2008- if this theory was right you would have expected other assets such as Gilts, Infrastructure and Gold to move similar to equities but they did not -equities were down around 30% but Gilts had a double digit positive return and both Infrastructure and Gold was also up. And as I have said before, go back to other periods (1987, 1973-74, 1930's etc) and you see that other assets have moved differently to the main market.

I agree that it is too simplistic to say have your money split 60/40 between the market and bonds as in 08 for example, Bonds were down about 10% that year, but my contention is that you don't need to go to the extreme of investing in say 15 non correlated asset classes- actual practice demonstrates that 6 or 7 will normally do the trick (Equities, Bonds, Gilts, Property, Infrastructure, Gold, Cash) especially as around half of these in practice are not correlated.

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Anonymous 1 needed this 'off the record'

Jan 07, 2013 at 12:06

Correlation spikes in periods of crisis, it is a fact not academic theory. I don't deny Gold isn't correlated to stocks (over time it's about 0.05) but it became more correlated in 2008 as did many other asset classes. Just because something was up slightly when stocks were down doesn't mean the correlation didn't increase! For an investor with, say a 20% overall portfolio loss in 2008, a 5% holding in gold would have done nothing much to protect you. I'm glad you've done well, hope you continue to do so and it's not my place to to criticise your portfolio....I just take issue when people talk loosely about diversification and correlation.

You say 6 or 7 uncorrelated asset classes do the trick but then list asset classes that have high correlation to each other. If you want the best, smoothest portfolio performance then you combine assets that have a low return series correlation (as close to -1 as possible) and a high time series correlation (as close to +1 as possible).....and by that I mean instruments that are negatively correlated (-1) but more importantly, are negatively correlated when you need them to be (+1). This is not academic mumbo jumbo, it's basic maths

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Anonymous 2 needed this 'off the record'

Jan 07, 2013 at 12:19

I have found this article and subsequent contributions interesting. It brings out for me many of the issues around asset allocation.

If we knew the future we would not need to allocate across the range of asset options - just pile into the winner.

But because we do not know accurately what will happen (who got out of equities before markets fell in 2008/9 and then got in again, who predicted QE, etc) we need to spread our money around several assets which perform independently/uncorrelated.

Doing well over recent times in equities or property does not ensure our money will have grown to meet our future needs when it is needed. Changing the asset allocation in response to markets is fine but is really moving towards a trading approach.

For me the important issue is what are uncorrelated assets? equities, cash, property, direct infra structure, direct commodities,??

It is not hard to think of dire events where some of these may behave in a correlated way.

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Anonymous 1 needed this 'off the record'

Jan 07, 2013 at 12:40

Well said Anon 2.

That's about it but within each of those you list there are diversification opportunities and also how they are invested in or traded. Certain commodities ,for example, are quite correlated to equities but then there are several that are negatively correlated which is ideal.

The real trick is to allocate by risk groups, keep an eye on changing correlation and only adapt your strategy if the long term correlations start rising between your assets. Do this properly and it's something that will last the test of time

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Chairman2

Jan 07, 2013 at 21:23

For ordinary mortals who dont have data on changing correlations

and returns on non-traditional investments the asset allocation decision seems to come down to a simple Be in the market or out of it?

If what you buy matters less and less then when you buy and when you sell matters more and more. Breaks all the rules by which investment advisers earn their unjustified salaries - be in the market at all times, reinvest dividends (lol!) and drip feed new money in on a regular basis.

Remember the only sure way to make money in the stockmarket is be a broker.

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