This is the fifth post in my series on the topic of asset allocation. Previously, I’ve discussed accessing asset allocation exposures, how asset allocation is the cornerstone of active portfolio management, provided an overview on the benefits of asset allocation and given you my thoughts on implementing tactical allocations in portfolios. In this final post I’d like to provide a quick refresher on the importance of asset allocation and how implementing some diversity across your portfolio can be beneficial.
The simplest way to add value through asset allocation is to be in the right asset class at the right point in the economic and business cycle.
Which is all well and good if you have a crystal ball – unfortunately no-one does. Given current levels of overall share market volatility, low interest rates, property market cooling and a weakening Australian Dollar, we think it’s worth taking a look at the fundamental aspects of asset allocation, as you assess the appropriate mix that is right for you across your portfolio.
No two classes are equal
Many asset classes move inversely or in a non-correlated manner to each other. The key is picking the right asset class for the current (or approaching) economic environment.
After sustained periods of rising prices, investors are often lulled into taking risk for ever-diminishing reward within a given asset class.
Conversely, after sustained pullbacks, assets can become cheap and priced to deliver strong future rewards.
Here is a broad idea of which asset classes tend to suit particular stages of business cycles:
The on-going assessment of asset class values and resulting portfolio adjustments is the key tenet of asset allocation.
Since 1990, no single asset class has outperformed on a consistent basis. It is clearly evident in the table below that yesterday’s winner is often tomorrow’s loser, and vice versa. You need to be active between asset classes to capture this alpha.
By avoiding overpriced assets and buying underpriced assets you can potentially achieve higher returns and lower risk over the course of a full business cycle. This is surely an outcome that all investors would be happy with!
Finding what’s appropriate for you
Whilst following the investment decisions of the market may be comfortable, it is rarely profitable.
Asset Class valuations may from time to time be at odds with the market’s “herd” mentality, but this should be a reminder that what may seem the “riskier” assets may well offer the best valuations and potential for future reward, whereas the “safer” assets may often be crowded and thus fully valued with lower prospects for future reward.
But by staying true to the asset allocation through whichever implementation means deemed most appropriate, an investor can potentially benefit their portfolio by:
- Actively managing portfolios to increase reward and reduce risk
- Partially smoothing the volatility of the business cycle
- Potentially increasing the total amount of alpha available for capture through multiple asset classes
- Providing the potential to perform in both rising and falling markets
Whilst by no means the only method of implementing asset allocation, ETFs offer important benefits that make them attractive tools for implementing simple asset allocation decisions.