Principally because each investor ought to assess the risk they are prepared to take, but it is also worth noting:
- Differing asset classes have varying returns. Over the five years to 31.12.12, equities as represented by the FTSE All Share returned just 13.6% versus a gain of 49.2% for bonds (Gilts); the old mantra that equities always work over the long-term is looking increasingly fragile and therefore it is worth considering all asset classes;
- Spreading investment over different asset classes (diversification) lowers the risk of being exposed to an underperforming asset class;
- In a low return and volatile world, investments need to work as hard as possible. Sensible asset alllocation may help to lessen the volatility of investment returns, reducing the danger of having to sell investments at a low point in their valuations.
Our asset allocation methodology has been developed to lower the risk of investing in a particular asset class at the ‘wrong’ time, when it is overvalued versus other asset classes. We agree with the Economist which said in a 2012 article: What tends to matter most for investors is the initial valuation.
When valuations are low, the odds shift in the investor’s favour. When they are high, the odds are against.
We think this approach of assessing the relative valuation can be applied to the different asset classes as well as to individual equities and stockmarkets.
How does our asset allocation methodology work?
In simple terms, we look at inflation adjusted expected yields on the asset classes and rank these according to risk.
Our starting point is a steady state of equilibrium where the real yield on cash is 2 – 3% and the excess yield on equities over bonds is 1.5 – 2%. At these levels the asset allocation would be roughly 20% cash, 30% bonds and 50% equities. We move away from this steady state according to how expected real yields change.
We therefore have an objective methodology which is governed by numbers and not subject to human whim.
It is important to note that we are not suggesting that this approach is some form of guarantee of investment success but we do believe that it lowers the risk of investing in assets at the wrong time.