Probably the most important part of investing

Probably the most important

Written by James Weir

James’s specialises in the theory and best practice of portfolio construction and management. His success within national and international investment banks led him to become a Co-Founder of Steward Wealth and he is a regular columnist for the Australian Financial Review.
September 25, 2014

Countless studies have concluded that asset allocation is probably the most important part of investing, but what is the best way to capture the performance and protection benefits it offers?

In 2007 the best performing asset class for Australian investors was domestic shares, but in 2008 it was domestic bonds. Last year it was international shares. The benefits of diversification are well documented and make sense, given that different asset classes such as bonds, shares, property and cash, can perform very differently under the same market conditions.

The challenge is to know how to divide a portfolio between those different asset classes, a process that is known as asset allocation. There have been numerous studies that have all concluded asset allocation is an important part of portfolio management, in fact, it’s probably the most important. So it pays to get it right.

Two schools of thought

There are two schools of thought when it comes to asset allocation. The static school holds that you can’t hope to forecast asset class returns, so instead, given that over time equities always outperform bonds, you divide your portfolio between bonds and equities, say 60/40 or 70/30 depending on your risk tolerance, and rebalance back to that same proportion on a regular basis. The problem with this approach is that it doesn’t pay any attention to how expensive an asset class is, so shares could be eye wateringly expensive just as you pour 60% of your portfolio into them, like in the US in 1999. And they might stay expensive for years after your initial investment but you keep buying more through rebalancing, like Japanese shares from 1989 to 2000.

The active school on the other hand maintains that you can in fact make meaningful forecasts of asset class returns to assess whether a particular asset class is expensive or not. The potentially enormous benefits are clear if this view is correct. The key here becomes the forecasting method that is used. Most methods are backward looking and extrapolation-based: we started at point A, we’re now at point B, draw a straight line between the two to forecast point C. Whilst this appeals to human nature’s recency bias that assumes what has just happened will continue, the fact is financial markets are a random walk, so it doesn’t work.

Forward looking forecasts

Ideally what we want is a forward looking method of forecasting that can help us stay underweight expensive asset classes and overweight the cheap ones. Luckily, a financial markets legend named Jack Bogle pondered the same problem and came up with an elegant, simple but highly effective solution. Jack’s model breaks down any market into the only three things that can drive returns: income (or dividends), capital growth that comes with rising earnings (or vice versa) and capital growth or loss that comes with changes in underlying sentiment. Jack was so impressed with how simple and effective the model is that he dubbed it The Occam’s Razor approach after Sir William of Occam, who in the fourteenth century declared the simplest explanation is generally the best.

The model looks at how far away each of the three drivers is from their long-term averages and then assumes they will revert to the mean over the next ten years. Ten years may sound like a long time, but when it comes to financial forecasting the longer the time frame the easier and more reliable are the forecasts. Likewise, trying to forecast where a specific index, like the ASX200 or the Dow Jones, is going to be on a particular date is a mug’s game. Nobody gets it right consistently over the long-term. Rather, the Occam’s Razor model aims to forecast growth rates, enabling you to compare relative returns between asset classes. So a portfolio’s capital can be allocated between different asset classes based on how much return investors are expected to receive for taking on the risk of not holding cash.

Ten year results

The Occam’s Razor approach to forecasting asset class returns, as refined and updated by Sydney-based consultant farrelly’s, aims to avoid the punishing effects of investing in overpriced assets and missing out on being invested in cheap assets. Starting 10 years ago farrelly’s has just celebrated the milestone by publishing its success rate, shown in the table below.

Australian shares International shares* A-REITS Bonds Cash Inflation

10 year forecast Sep. 2004 (% p.a.)

9.8 8.0 8.3 5.8 4.8

2.5

Actual Sep. 2004 – Sep. 2014 (% p.a.) 10.0 7.8 2.5 6.0 5.0

2.7

Source: farrelly’s Dynamic Asset Allocation Handbook Sept 2004, All Ords Accumulation Index, MSCI World Ex Aust, UBS Govt Bond Index, RBA cash rates, Australian CPI

* 50/50 hedged and unhedged

 

The results are impressively accurate, with the exception of A-REITS (also known as Listed Property Trusts) where distributions were slashed from their long-term average after a near-death experience in the GFC.

Preferred model

Given the conclusion that there are clear advantages to active asset allocation if you can find a reliable forecasting method, farrelly’s model provides an ideal foundation on which to more confidently allocate a portfolio’s capital. A key part of Steward Wealth’s low volatility investment philosophy is avoiding overexposure to overvalued asset classes forms, so working with farrelly’s Dynamic Asset Allocation model is integral in achieving the aims of, and capturing the tremendous benefits from, effective asset allocation: working out how much to put in to the various asset classes, and which ones to avoid.

This article reflects the views of the author and not necessarily the views of Steward Wealth.

This information is of a general nature only and nothing on this site should be taken as personal financial or investment advice, or a recommendation to buy or sell a particular product. You should seek advice from Steward Wealth who can consider if the general advice is right for you.

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