Valuable insights about asset allocation


Last message on global investing looked at the power of value investing. This message shows that asset allocation can add investing power as well.

Here is a summary of an article about asset allocation provided by my friend, Thomas Fischer at Jyske Bank.

How asset allocation can boost portfolio performance.

Investors always want the best risk-adjusted return. This desire is hard to achieve in the current climate of high risk and low returns.

Modern portfolio theory suggests however that one can allocate assets more efficiently in any situation to maximize return for any level of risk.

Winners and Losers

Many investors have recently seen their portfolios decimated. Yet others have gained despite the turbulence in markets. The difference is caused by how much correlation (i.e. how closelyinvestments in the portfolio were linked).

Investors with plunging portfolios mostly had securities which were positively (orclosely) correlated. The values of all these assets moved in the same direction. Examplescould be IT equities, or US equities or even equities in general. Since equities generally move together, the benefits of diversification within a stock portfolio are limited.

Modern portfolio theory was originated by Harry Markowitz in the early 1950s culminating in his receipt of the Nobel Prize for Economics in 1990.

Markowitz showed that smaller number of asset classes (such as equities, fixed income/bonds, cash, real estate, precious metals, alternativeinvestments) could be used for better diversification instead of thousands of individual securities.

He showed that the correlation between a few asset classes was easier to evaluatethan trying to determine the correlation between tens of thousands of individual shares.

He argued that by understanding the correlation between different asset classes, one could efficiently diversify one’s portfolio, and optimize the risk-adjusted rate ofreturn.

Markovitz´s theorized that diversification within an asset class is a necessary but not sufficient condition for reducing risk. More important is that one diversify across asset classes.

Not all asset classes are affected equally by any prevailing situation.

This was recently seen when stock markets in general collapsed, but bonds and real estate, performed relatively well. There is a low or negative correlation between such asset classes. For example, economic growth boosts equities and often increases inflation, which negatively affect bond prices.

Consequently, one can therefore blend equities and bonds and reduce the risk and volatility whileincreasing the return of the portfolio over time. This means that investors should invest in asset classes with low or negative correlation and diversify in each asset class.

For example, an efficient portfolio of equities would include several non related currencies. (e.g. Euro and non-Euro), a selection of small-, medium- and large-cap, both value and growth stocks, preferably in different sectors etc. Similarly, one´s portfolio of bonds should include, for example, Euro and non-Euro denominated bonds, in both industrialized and emerging markets,preferably both Government and corporate bonds, both investment grade and high-yield, with varying maturities.

Only sufficient diversification within each asset class and most importantly, across asset classes, will insulate investors from swings in the market, recessions, hyperinflation, currency devaluations etc., and prevent the kind of plummeting portfolio values experienced recently.

Asset allocation is more effective than market timing. Market timing can generate short-term gains, but has not proven to be effective in the long-term, as major moves in the market are frequently missed.

The actual selection of individual securities (style allocation) can also positively affect portfolio values, but, as with market timing, only contributes marginally to the return on any long-term investment.

One of the main advantages of asset allocation it is easy for banks or investment managers to optimize portfolios tailored to the preferences and personal circumstances of each individualinvestor.

A manager can include the investor’s risk tolerance, expectations of return, need for liquidity, investment horizon, reaction to market changes and experience and tailor each investors asset allocation.

Jyske Bank (www.jbpb.com), incorporates asset allocation as an integral part of its investment and portfolio management services. Jyske Bank uses several strategies (based on varying proportions of cash, bonds and equities), which can be tailored to suit the situation of each client. For example, an investor, who likes risk (e.g. having a long investment horizon, being relatively young, requiring little need for liquidity) is more suited to a growth strategy where equities and bonds are over weighted and under weighted, respectively. Other older investors who want to protect what they have may need more bonds than shares.

Jyske Bank uses asset allocation in other products, such as its leveraged (geared) product the currency Sandwich where clients can diversify between investment classes and between various low-interest rate loan currencies to simultaneously diminish risk and earn potentiallyhigh returns.

Thomas Fischer FISCHER@jyskebank.dk"

I agree with Thomas. Smart investors will combine asset allocation with value investing and incorporate them into a PIEC investing plan. That a way to have really powerful international investing! Until next message, good investing to you.

Gary


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