While studying for my next exam, I came across the following quote in the revision manual:
“It is better to be in the worst performing stock in the best performing sector, than the best performing stock in the worst performing sector”.
This quote alludes to the importance of asset allocation; the broad type of investments selected by the investor, rather than the specific funds or stocks.
Asset allocation is really, really important.
Some academic studies have shown that asset allocation accounts for around 90% of total portfolio returns, with other studies suggesting this figure is closer to 60%.
It is arguably far more important to investors than fund selection or market timing.
You can pick the very best performing fund in a particular investment sector, but if that investment sector is the worst performing, being in the best fund will still result in poor performance.
However, even the worst performing fund in the best investment sector is likely to deliver a satisfactory return.
Sure, you could have done much better by investing in the best performing fund in the best performing sector, but this is impossible to achieve as it would require a degree of foresight unavailable to any investor.
Fund selection still matters; it makes sense to select funds for your portfolio based on a robust fund selection process, seeking to identify factors including consistency, risk-adjusted returns and cost.
But in the grand scheme of things, getting your asset allocation decisions right is far more important than being able to select the ‘best’ funds in each asset class.
Our own approach to asset allocation uses optimisation models which aim to construct asset allocation portfolios designed to deliver the maximum rate of return for any given level of risk.
This works on the basis that there is an efficient frontier for investment returns. For any given level of risk, it is not possible to exceed a certain level of returns.
The most efficient portfolios therefore offer the maximum possible returns for a given level of risk, and are said to be ‘efficient.
Here is an example of an efficient frontier model for a ‘low medium’ risk investor:
In this example, this is the most efficient position an investor can hope to achieve when taking this level of risk.
We often come across ‘inefficient’ investment portfolios, which sit below the efficient frontier line.
These can be quite easily adjusted so that, for the same level of risk, greater investment returns are available.
Do get in touch if you would like to find out more about optimising your own investment portfolio and focusing on asset allocation rather than fund selection.
