Has asset allocation had its day?

Dec 5, 2018 | Tony Byrne's View

Ever since the successful academic studies of Professor Harry Markowitz it has been generally accepted that asset allocation or diversification of risk is the best way to achieve reasonable investment returns whilst at the same time minimising risk.

Professor Harry Markowitz was famous for winning the Nobel Prize for Economics after a 38 year study of the US stock market between 1952-1990 which concluded that regular portfolio reviews of at least 3 times a year and re-balancing of share portfolios produced superior returns with lower levels of risk. This was the birth of Modern Portfolio Theory which has been the favoured investment management technique of financial advisers ever since. It also happens to be the favoured investment management technique of our regulator the Financial Conduct Authority (FCA) and this is where the problem lies.

The rationale behind asset allocation is that by investing in different assets such as shares, property, fixed interest and cash you achieve diversification of risk because such assets are not highly correlated. This means is that when share prices rise for example, property prices do not rise in unison. There is a lack of correlation and as a result there is less risk to a portfolio of investments that contains all 4 asset classes because when the stock market falls in value the shares will fall whereas the rest of the assets may rise, remain the same or fall in value less. The trouble is that this isn’t always the case. In 2008 for example, the year of the global financial crisis, all asset classes fell in value simultaneously. The lack of correlation between the 4 different asset classes made no difference during that period in time.

Furthermore, during the last 20 years or so global stock markets appear to rise and fall in unison because, of course, the world has become smaller and global trade has increased substantially. So there is now much greater correlation between diversified global stock markets than previously.

The third factor I have noticed is that fixed interest stocks or bonds have never looked less appealing as an asset class ever before during my working lifetime, with the exception of index linked gilts. Why is this? Well, it is because interest rates have fallen to historically low levels which has resulted in historically low yields on government stocks and a consequent rise in bond values. At current low yield levels and with interest rates on course to rise soon, the value of fixed interest stocks is likely to fall. In fact the yield on fixed interest stocks looks likely to be very low for years to come. So why bother investing in such stocks at all for the foreseeable future?

What with the current turmoil in worldwide stock markets there is an argument for not investing in shares currently as well.

Demand for commercial property is likely to reduce in the future as more people work from home. Also if interest rates rise, that will have a dampening effect on the economy, which will mean less demand for companies for commercial property.

As for cash forget it. Who wants to earn less than 1% a year?

So has asset allocation had its day? Well, not really. All is not as bad as it seems currently. The fact is that all markets go through their ups and downs or cycles. That is all that is happening right now.

The good news is that there are definitely strategies you can use in order to improve the returns on your investments and pensions.

Firstly, you can review your attitude to investment risk. If you decide to increase it then you will automatically invest more into shares and less into property, bonds and cash. If you are invested in the Intelligent Wealth Fund you will be invested in the 9 investment sectors with the greatest growth prospects over the next 5-10 years anyway. These 2 strategies alone will increase the likelihood of you achieving decent investment returns in spite of economic conditions which make the usual asset allocated portfolio challenging in the years ahead.

As for asset allocation, is it dead? I don’t think so. Modern Portfolio Theory has an excellent long term track record. It remains a relatively safe and conservative strategy for securing consistently decent returns that are likely to exceed both interest rates and inflation over the longer term.

If you have any concerns over your existing investments and/or pensions and you would like a review, why not get in touch with us? You know it makes sense.

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