By Phil Wellington - May 22, 2023
When it comes to asset allocation, it is important to focus on the long-term plan which can stand the test of time. At PortfolioMetrix, we achieve this by: What is asset allocation? Asset allocation is the process of carefully selecting and mixing different asset classes to balance the risk and reward
characteristics of a portfolio. Asset classes, broadly, include shares (equities), bonds, cash and real assets (e.g., Property, Infrastructure & Commodities).
Asset classes display different risk and return characteristics. Less risky asset classes (cash or bonds) are expected to
have lower returns, whilst riskier asset classes (equity) have higher expected returns. You should expect to be rewarded
through higher returns for taking more risks.
Risk Control
Your risk budget, a combination of your risk tolerance and how much risk your financial plan calls for, is the key piece of information we need to start building your client's portfolio.
Each asset class has different risk characteristics and so will react differently to what is happening in the world. Using historic data, we can understand how they have individually reacted in the past to help interpret how they may react in the future. This will help guide us in how much of each asset class should go into a portfolio.
Combining asset classes together (diversification) also results in lower risk. For example, bonds often rise in price when equities fall, and vice-versa, so combining them together can result in a portfolio that is more predictable over time. Understanding these relationships is the key to building a portfolio’s strategic asset allocation.
Strategic Asset Allocation
Strategic asset allocation is the long-term target blend of asset classes in portfolios which are expected to deliver the best returns for a specified level of risk.
Strategic asset allocation is the key to risk control. Research has shown that most of the risk (up to 90%) in a portfolio is determined by strategic asset allocation. That’s why we spend so much time selecting an appropriate mix of asset classes for portfolios.
Generally, a higher-risk client would expect to have more equities and less cash than a lower-risk client, as shown in the diagram below. The more risk you want to take, the higher the proportion of risky asset classes (e.g. equity) you should have in your portfolio, and the fewer lower-risk asset classes (e.g. cash and bonds).
We review our strategic asset allocation periodically when we feel changes need to be made in order to improve portfolios, trying to keep the risk of your portfolio consistent over time. As the strategic asset allocation focuses on the long-term, generally only small changes are made at these reviews and the changes are shared with advisers we partner with.
We break the global investment universe up into 15 different sub-asset classes, giving a diverse blend of asset classes in portfolios. For example, the asset allocation of a mid-risk portfolio for a UK investor is shown below.
Tactical Asset Allocation
Even if we could foresee future events, financial markets can react very differently to how industry experts might expect. Some people try to make short-term market predictions and make material changes to portfolios. Often these decisions change the risk characteristics of the portfolio. This sort of decision-making is more commonly known as tactical asset allocation.
We avoid making short-term predictions and changes. A big reason for this is that we don’t want to change the risk level of a portfolio away from the original risk budget. But it is also because tactical asset allocation is so difficult to do correctly and consistently. You need to get many things right to benefit:
1. Predict future events correctly;
2. Predict how markets will react to those events correctly; and
3. Get steps 1 & 2 right twice (once when you make the tactical changes and again when you reverse them).
For example, had you known how serious COVID was going to be, you might have thought selling your portfolio would have been a good idea in 2020. In fact, despite a sell-off initially, global equities dramatically outperformed cash over the year. Holding a portfolio of different asset classes over the period would have been much better.
This is why we do not make big tactical changes to asset allocation and would not, for example, attempt to sell portfolios to cash when markets are falling (market timing).
Our job is to run the best possible portfolio to reflect the level of risk budget agreed on. We see investments as long-term in nature, fitting in as they do with long-term financial plans, and so we ensure that the decisions we make in it are also strategic and long-term in thought and nature.
About Us
PortfolioMetrix is a global investment manager operating in the United Kingdom, South Africa, and Ireland. We support independent advisers to scale sustainably without compromising the quality of advice they provide to their clients. Our risk-based investment process ensures carefully calibrated portfolios that deliver predictable outcomes specific to each investor.See how we partner with advisers. Our technology,WealthExplorer™allows the adviser to extract the synergies between financial advice and investment management, providing deeper client insights and more robust recommendations.
For more information, send us an email atengagement@portfoliometrix.co.uk
PortfolioMetrix cannot accept any liability for loss for doing so.The value of investments, and the income from them, can go down as well as up, and you may not recover the amount of your original investment. Past performance is not a reliable indicator of future performance.Portfolio holdings and asset allocation can change at any time without notice. PortfolioMetrix Asset Management Ltd is authorised and regulated by the Financial Conduct Authority.
