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Asset allocation

Asset allocation simply means deciding where to put the money that we are saving or investing. As we've already seen, there is a wide range of investment assets we can buy as an alternative to keeping cash in a bank or building society. On the next few pages we will be looking at the main investment asset classes: equities (shares), fixed interest (bonds), property, and what are referred to as ‘alternative assets’. The other main asset class is cash, which from the point of view of the private investor means flexible savings accounts where we have access to the money at short notice. Let’s look briefly at each of these.

Cash

Whatever our situation, it would be sensible to keep some part of our total savings and investments in cash. There is no reason why it shouldn't all be in cash, and unless you feel able to set money aside for several years then cash is probably where it should be. The advantages are ultimate flexibility and fairly predictable returns. The risks to your capital and income are low provided you stick to mainstream banks or building societies, and lower still if you have no more that about £20,000 in any one institution.

The main risks associated with cash are inflation and economic growth, and variability in interest rates. The interest earned on savings account will be subject to income tax. Provided you shop around for the best interest rates and keep shopping around, you are likely to get a rate of return a little above bank base rate. Best buys are listed in the financial pages of daily newspapers and online.

Fixed interest (bonds)

A bond is financial asset that is essentially an IOU. The bond issuer promises to redeem the bond on a specified date and in the meantime bondholders receive an income (often called a coupon) that is usually expressed as a percentage of the nominal amount of the bond. Other fixed interest investments include National Savings, preference shares and debentures, and fixed rate bank or building society bonds.

The rates of return on government bonds (gilts) are typically slightly less than for cash. With conventional gilts the income is fixed. With index-linked gilts, the income and redemption values are linked to inflation. Gilts (and National Savings) are the safest investments available.

Other bonds issued by companies and organisations have rates of return higher than those for gilts, but there will be some risk of default. The highest rates have the highest risk. Whilst there is no need to diversify risk for gilts, you would probably want to spread any investment in corporate bonds. You can invest in bonds through pooled funds or directly.

The rates of return on fixed interest investments tend to be comparable to cash although there may be some tax benefits, for example with National Savings. There is an inflation risk with conventional bonds and an economic growth risk with all fixed interest investments. However, the returns although relatively modest, are much more predictable than for other asset classes, and risks are low except for junk bonds.

Equities (shares)

We have already discussed the advantages that equities have by virtue of their link to economic growth, and the disadvantages of excessively volatile markets. Equities are essentially long-term investments unless you have the time and inclination to research individual shares and ‘play the market’. If you do that, you must realise that you stand a good chance of losing money and that the costs of frequent trading will reduce your profits.

Leaving aside speculative activities, you would be well advised to diversify equity investments either by buying a reasonably wide of individual shares, or through some form of pooled investment such as unit trust, investment trust, or exchange traded fund. Pooled investments provide a high degree of diversification, and you often have a wide choice of investment styles to choose from. The downside is that there is usually an up-front charge when you buy into a fund, and a regular management charge thereafter. The costs are higher for an actively managed fund because the manager is selecting individual investments in the hope of beating the market or benchmark. Passive or tracker funds are set up to replicate an index (such as the FTSE 100) and as a result their fees are lower. Exchange traded funds are a novel form of tracker with relatively low costs.

You can also invest indirectly in equities through products such as guaranteed equity bonds, which combine some aspects of fixed interest investments with a link to changes in equity markets. You need to be very clear about the effect of this linking because some equity bonds can be very poor investments if equity markets fall.

If you are investing for the long term (15 years or more) then equities should be high on the list of assets you should be considering.

Property

Many of us have an investment in property because we own at least part of our home. Historically, property has provided capital returns that are comparable to equities but it would be dangerous to assume that the growth in house prices seen over the past few years will continue. There is every reason to suppose that property as a whole will grow broadly in line with the economy but it can’t grow faster indefinitely. Over 60 years or so the growth rate of house prices in the UK has tracked the economy pretty well, although there have been times when the rate has been higher and lower.

Because the amount of money tied up in our homes is likely to represent a very significant investment for many people, it is debatable whether additional investments in property would be appropriate. Property is difficult to diversify except through pooled funds, and can be difficult to liquidate and expensive to manage. However, the rate of return for rental property can be attractive, and for people with the skills to buy, improve and manage properties it is an asset class worth considering. However, we are then talking about it being more of a job than an investment!

Alternative assets

This class of assets could include anything that doesn't fit into any of the classes above. Typically, it would include investments in private companies, commodities, collectibles (antiques, works of art etc), derivatives, and hedge funds. In general, you need to have special knowledge before considering an investment in anything of this sort. Investments in real assets should provide some link to economic growth but don’t as a rule provide an income stream. Shares in private companies might provide for income but the attraction is usually above-average growth. Derivatives and hedge funds are highly speculative and usually short-term investments.

Derivatives are financial assets that are derived from other real or financial assets. For example, futures and options are derivatives: they give you the option or obligation to buy or sell the underlying asset (commodity, currency, share, or market index for example) at a specified price at some date in the future. Originally intended to provide a hedge against risks for commodity producers and consumers, derivatives are increasingly used to make highly speculative leveraged bets on markets and individual shares. Since they rarely involve ever owning the underlying asset, the returns to derivative trades can only come from other traders who are active in derivative markets.

Derivatives are valuable tools for professional investors and commodity and currency traders because they enable them to reduce risks that cannot easily be diversified. There is a cost for what is effectively insuring against market movements or other risks, and that provides a profit for the counter parties. However, claims that derivatives can generate significant returns suggest smoke and mirrors. If you have made a lot of money from something without adding value, then somebody must have lost it.

Overseas investments

As well as a choice of asset classes (equities, fixed interest, cash etc) we also have the choice of where to invest. We are not limited to just UK equities, for example, we can invest in every major economy (and some minor ones too). Of course, many large companies trade worldwide and by investing in them we are linking our investment returns to other economies. It can be argued that whilst all economies go through cycles of boom and bust (or at least high and low growth), they don’t necessarily do it all at the same time. Spreading our investment around the world should in theory give us better diversification than we can get from investing in a single country. However, we will then be exposed to currency exchange rate changes. If we spend most of our money in the UK, then we want to maximise our spending power in the UK. We might get improved returns by having some of our investments overseas but the extra management costs associated with that plus the exchange rate risk tend to cancel out the benefits – except to the fund managers. Having said that, speculating on foreign currencies may appeal to some investors, and these days it is easy to do.

Deciding asset allocation

Basically, the aim of asset allocation is to achieve the highest returns for the lowest risk. By combining assets from each class in a single portfolio of investments, it is possible to reduce the volatility of returns (which is the classic measure of risk). However, the classic measure of risk does not take into account the way that risk on market-based investments reduces over time as more of the returns accrue from the income stream. Instead of trying to mix assets in the hope of reducing short-term volatility, it is arguably better to think in terms of your investment horizon (how far ahead you want to look) and the extent to which you are already invested by owning property and through pensions or endowments.

Asset allocation also depends on individual appetite for risk and inclination. If you feel very uncomfortable seeing the ups and downs of the markets, and have no interest in researching companies or other assets, then you should avoid direct investment in equities. Think cash, National Savings and government bonds, and maybe an endowment. If you are nearing or already in retirement, you should be mainly in cash and fixed interest anyway but maybe with time to spare you would enjoy dabbling in shares. There really is no one right mix of assets, although the conventional wisdom is to have some part of your total assets allocated to each of the main classes. The balance between say equities and the rest will depend on your investment horizon and taste for risk. For example, if you are looking ahead 20 years or more and have the nerve to sit through market falls, then you may well be thinking about having 70% of your investments in equities and the rest in cash or bonds.

Let’s have a closer look at equities.

 

  9 October, 2008 © 2008 K.R.Wade and Co Ltd prev page next page