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Select asset classes – 1. Get to grips with allocation

Building your portfolio is not simply a matter of selecting a collection of stocks, but also considering the balance of the different economic sectors and industrial categories. In other words you must guard against putting all  your eggs in one basket.

However, for a more balanced investment portfolio you don’t just want to concern yourself with what blend of stocks to invest in. You should also consider additional ‘satellite’ asset classes that can offset any losses on your ‘core’ equities holding. There are a number of assets that can contribute in this diversifying role; their characteristics, behaviour, risk/reward profile and optimum allocations per your risk tolerance, are the subject of this lesson.

How asset allocation dampens risk

If you stand back for a moment and think about all the unforeseen events, risks and uncertainties that could present in the life of an investment, there’s clearly a lot to consider. At the macro level, the global economy could swing from steady growth to recession. How would that impact your portfolio returns?

Or at the micro level, one of the shares you own has been subject to a stock split as the company seeks to improve trading liquidity in the shares. Will the share price appreciate as a result? Should you add to your holding? Would increasing the proportion of your portfolio taken up by this share expose the overall portfolio to more risk for limited reward?

What is asset price correlation and how does it affect diversifying to lower risk?

In order to counter-balance losses in one part of the portfolio, we need to find an asset classes that, for example, performs best in conditions of economic downturn. This is the heart of asset allocation theory. Its most ardent advocates would have it that the proportions in which you hold the main asset classes in your investment portfolio – and the ongoing adjustments you might make – is in the long-term the best driver of investment returns.

Assets with low price correlation between each other can be employed together in a portfolio. As we are looking at this from the perspective of stock investors, let’s assume that the portfolio’s ‘core’ is stocks, say 80% – you now need to find a volatility dampener that acts against reversals in the equities portion of the portfolio – an asset with the potential to rise, or not fall, in value when stock prices are under pressure.

Why 60/40 hasn’t work well recently – the ‘hunt for yield’

If you invest across the asset class range you are in effect diversifying your risk. Traditionally, for example, investors held 60% in equities and 40% in government bonds, the latter as a source of secure income and as a capital preserver. But that strategy has been much less effectively deployed since (and arguably before) the financial crisis of 2008/09 and the advent of an historically unprecedented low interest rate environment. This background has forced investors to hunt elsewhere for yield (return on income and/or capital from shares). This has pushed investors to look to riskier assets, by comparison to bonds, and therefore to invest proportionately more in equity markets.

Nevertheless, diversifying risk through adopting an asset allocation strategy – by including bonds and other asset classes in your portfolio ­– is still an essential element of portfolio construction.

You should think of asset allocation as akin to making a decision about what to wear given a forecast of unpredictable weather: What will you take out? Umbrella, coat, hat, jacket, gloves? Maybe bring them all along just in case, or perhaps one or two items because you assess the risk of rain is negligible, so you leave the umbrella and coat behind.

What’s the difference between asset v sector and regional allocation?

Before we move on, it is worth stressing that asset allocation is distinct from sector allocation. The latter concerns the economic sectors of a stock, such as materials, consumer cyclicals, financials and so on, while asset allocation and diversification is about the respective weighting of the asset classes within a portfolio.

Also, we should not forget about regional diversification, such as between US and European stocks, or emerging markets and the UK. Stocks in all of those regions will have different characteristics not just in terms of the types of companies listing on stock markets but the nature of the economy itself – is it export-led manufacturing economy or a services-centric economy such as the US and UK? Which region will perform best. China seemed to recover much more quickly and in better shape than the US and Europe, for example. Does that mean it is time to consider an asset allocation decision that is regionally based – in other words investing in Chinese assets, be it shares or bonds, with the country’s debt notably attracting recent interest from western buyers.

Major asset classes explained

Financial assets are divided into classes because they have importance differences not just in form and content but also how they behave under differently under the same economic conditions.

The variance emanates from the unique characteristics of the specific asset classes themselves.

asset allocation matrix

Courtesy Vanguard UK. Data: Bloomberg.

The two main asset classes are equities (stocks and shares) and debt instruments known as bonds.

Below we have grouped the major asset classes, looking at each asset’s risk-return profile.

Equities

Equities are the riskiest of the major asset classes. No guarantee that you will get back all that you invest. Instead as investors we are dependent for a return on the performance of the company. You should consider an element of regional diversification across equities.

The main regional breakdown is:

  • UK
  • Europe
  • North America
  • Japan
  • Far East ex Japan
  • China
  • Emerging markets
  • Frontier markets

Fixed income

Fixed income is the safest form of investment, in particular lending to governments. Investing your money in the government bonds of a stable and prosperous country such as the UK or US, guarantees payment of the coupon (interest rate) and the principal amount upon maturity.

The main fixed income products are:

  • Cash deposits / savings accounts
  • Government bonds
  • Corporate bonds
  • Money market funds

Property

Property comes in three main categories (plus land). Property is relatively uncorrelated to equities, less so with bonds and even less so with investment-grade corporate bonds. Liquidity is a concern when it comes to investing in property. You have a number of choices depending on your needs. You can go down the collective vehicle route by investing via a fund or real estate investment trust. These funds invest directly in property: commercial and industrial mostly. Alternatively you could invest directly in bricks and mortar

  • Residential property
  • Commercial property
  • Industrial property
  • Land (eg forestry)

Commodities

Industrial commodities are highly cyclical, meaning demand is sensitive to economic expansion and contraction.

Hard commodities – mining and extractive: precious metals, industrial metals, oil, coal, natural gas etc

Soft commodities – agricultural products and livestock: cotton, pork, wheat, coffee, soybeans etc

Currencies

Major internationally traded pairs. Foreign exchange can be held as a hedge against adverse currency movements. If you invest in a US stock through  UK stock broker then you are exposed to an element of exchange rate risk, depending on which currency you make the purchase in – dollars or pounds. At some stage you will eventually need to liquidate which means ultimately converting to your home currency.

The US dollar as the major reserve currency of the global economy can rise in value in periods of uncertainty and economic dislocation as investors seek out safe havens. The Swiss Franc and Japanese Yen provide a similar safe haven bolt hole in times of crisis.

Currency movement between the major trading pairs are relatively stable and therefore holding any of these currencies as cash should not present problems, although most of us are likely to hold the currency of the jurisdiction in which we are based. However, if the value of the pound falls the value of sterling-denominated investments falls with it. These are risks that can be mitigated by buying hedged mutual funds for example or even money market funds denominated in dollars, yen or Swiss Francs.

Hedge funds

Hedge funds are collective investment vehicle that seek to beat the market with a variety of strategies.

Controversially perhaps, one of the most popular of the strategies adopted by these funds is shorting stocks. This where you benefit from a fall in price by borrowing shares at a higher price in the expectation the price will fall and the shares can be returned to the owner by buying them back at the new lower price and pocketing the difference.

Various hedge fund strategies explained

Other strategies include will include: the obvious traditional stock-picking by ‘going long’ on shares; arbitrage (profitable exploitation of pricing anomalies); quant-driven (as in quantitative numerically driven decision-making without human intervention) funds; high-frequency algorithmic trading and the ever-popular global macro approach, where macro-economic and geopolitical events are analysed to exploit profitable opportunities that may arise across financial asset classes as a result of those events.

Hedge funds have high minimum investment amounts, which means you will need to be a high net worth individual to access one of these funds. However, there are investment companies that provide access to retail investors, such as the BM Macro investment trusts. Investment trusts trade on the stock market in the same way as ordinary shares.

Venture capital and private equity

In recent years more and more companies have been choosing to stay private longer, depriving retail investors of the opportunity to buy in at the ground floor for maximum potential rewards. Venture capital trusts (VCTs) are one of the few avenues open to ordinary folk to get in on the action. VCT come with attractive tax allowances provided you are willing to tie-up your money for five years.

Enterprise Investment Schemes are another option. These investment must be held for three years to attract the generous 30% income tax relief.

Again, investment trusts can help investors with smaller amounts to invest to access these private capital markets.

Collectibles

Collectibles are items that are collected for their rarity value. Because collecting is subject to the vagaries of taste, it makes this asset class especially speculative. But if you think you know more about what’s happening on the art scene than most, then picking up an up and coming artist’s work could land you a work by the Banksy. But as you can imagine, it’s a bit hit and miss.

Popular collectibles include:

  • Art
  • Wine
  • Stamps
  • Classic motor cars
  • Coins

Cryptocurrencies

Some would argue that cryptocurrencies such as a bitcoin are not really asset classes at all, supposedly because they have no intrinsic value and has no yield. Whatever your view on that, there’s no sign that bitcoin is going away any time soon. Although it might be stretched to describe bitcoin as safe haven, alongside the massive money printing by central banks and the risk of inflation re-emerging, means it is gaining traction as ‘digital gold’ because of its limited supply. In that sense, bitcoin is a commodity similar to gold.

Let our model portfolio allocations be your guide

BuyShares has created asset allocations that seek to compensate for the low returns available from government bonds by reducing the fixed  income portfolio weightings across all the portfolios.

In turn, equities make up a fairly large chunk for a conservative portfolio, but you should assume the stocks would show a bias to blue-chip, solid dividend payers.

Aggressive investors may buy high-yield corporate bonds for their bond allocation. The 10% ‘other’ allocation for the aggressive portfolio could be a mix of derivatives with perhaps 1 or 2% in cryptocurrencies.

The commodities allocation will of course vary in exact composition across the risk range represented by the portfolios.

Moderately conservative and moderate portfolios might focus on energy and industrial metals, while the aggressive investor might go for an industrial-cum-precious metal such as palladium that has been in a bull run because of its usage in catalytic converters.

The portfolio allocation area intended as a flexible guide.

Asset allocation for conservative, moderately conservative, moderate, moderately aggressive, aggressive portfolios are set out and explained below:

Portfolio Equities Bonds Property Commodities Cash Other
Conservative 25 50 0 0 25 0
Moderately Conservative 35 35 0 20 10 0
Moderate 50 20 0 25 5 0
Moderately aggressive 70 0 0 25 5 0
Aggressive 85 0 0 5 0 10

 

Conservative portfolio asset allocation

consrevative allocation

Moderately conservative portfolio asset allocation

moderately conservative

Moderate portfolio asset allocation

moderate allocation

Moderately aggressive portfolio asset allocation

moderately aggressive allocation

Aggressive portfolio asset allocation

aggressive allocation

Continue to part 2 – strategies for allocation profits

Now we know what asset allocation is all about, we next need to think through the sorts of strategies that are available when allocating to the various asset classes.