There was an interesting blog on Moneyweek recently, asking whether the notion of asset allocation is ‘self-serving nonsense’.
The blog was written by Tom Bulford, a former fund manager who now provides private investors with analysis of the penny share market.
It is worth spending five minutes reading the blog, if you are interested in the subject of asset allocation. It is also worth noting that Bulford misses the point and describes geographical allocation, rather than asset allocation.
Asset allocation describes the investment strategy of allocating parts of an investment portfolio to different asset classes.
The main four asset classes are cash, fixed interest securities, equities and commercial property. These four asset classes can be further divided into sub-asset classes, for example gilts and corporate bonds within fixed interest securities.
Because each investment asset class behaves differently, making asset allocation decisions is very important for risk management within an investment portfolio. Academics continue to argue about just how important asset allocation is as a contributor towards performance.
The main studies talk about the variance in performance made as a result of asset allocation. That is to say how much the performance of one portfolio differs from another because of asset allocation decisions.
In some studies, this variance in performance is shown to be over 90%. The most comprehensive asset allocation study to date, carried out by Ibbotson and Kaplan twelve years ago, asked whether asset allocation policy explained 40, 90 or 100% of performance.
This study concluded that asset allocation explained 40% of the variation of returns across funds and that it explained virtually 100% of the level of fund returns.
What this means is that asset allocation decisions are very important.
The decisions made by investors to allocate a part of their portfolio to equities or fixed interest securities are probably more important to the contribution to performance made by timing the markets correctly or selecting the best performing fund, not that either of these actions are possible to achieve with any degree of consistency!
Our investment philosophy here at Informed Choice states that the bulk of long-term returns come from an asset allocation strategy. We also believe it is possible to add extra value through tactical asset allocation decisions and fund selection.
Asset allocation certainly isn’t a lie and can definitely not be described as ‘self-serving nonsense’. It is a shame that the former fund manager writing for Moneyweek did not better explain the difference between asset allocation and what he was trying to describe.
Photo credit: Flickr/pernilliarydmark
