Asset Allocation – an introduction

It’s quite likely that you have heard the term Asset Allocation. It may mean different things to different people, so I will try to give you an overview of where the term comes from and what I mean when I refer to it.

First some history: The pioneer of asset allocation was Harry Markowitz. As early as 1952 he was writing on diversification, efficient frontiers, and modern portfolio theory. Understanding Markowitz is about recognising that most investor’s requirements revolve around obtaining reasonable investment returns without excessive volatility (risk). In other words, it’s not about high returns, it’s about blending different asset classes to produce average to good results at lower risk.

Since Markowitz, further studies have concluded that asset allocation constitutes the most important step in portfolio construction, accounting for more than 90% of the variability in portfolio performance over time. (G.P. Brinson, B.D.Singer, G.L. Bebower, “Determinants of Portfolio Performance II: An Update”, Financial Analyst Journal, May-June 1991)

Another interesting person to read up on is the psychologist Daniel Kahneman, who won the 2002 Nobel Memorial Prize in Economic Sciences for his work on the psychology of judgement and decision making. Most importantly, Kahneman points out that individuals are more depressed with investment losses than they are satisfied with equivalent returns. In other words, people hate losing money more than they like making money. Which brings us back to Markowitz’s theory that, although people might think they want high returns, what they really want is reasonable returns with the minimum amount of risk possible.

If we were to put Markowitz’s work into a diagram, it would look something like this:

We can refer to the return on cash as the “risk free rate”. This will, of course, vary depending on your base currency. If you take all of your money out of the bank and put it into private equity, there is a chance of very high returns, but the risk will quite literally go off the chart. However, if you diversify through cash, bonds, base currency stocks, overseas / emerging stocks, property and alternatives, you will find that the risk increases, but not by a huge amount. This means it is possible to put a little of your money into more racy investments without massively increasing your overall risk.

The actual weighting you should allocate to each asset class will depend on your attitude to risk, which we will consider in a later post. It will also differ for regular monthly investments vs lump sum investments. For now it’s enough to know that this “strategic asset allocation” is used to form the core of an investment portfolio, allowing you the peace of mind to get on with more important things!