Guiding principle 4: Focus on the investment mix
This is the fourth blog in our ‘Guiding Principle’ series and you can view the articles in the rest of the series here.
When investors are looking at how they can make their cash work harder, they broadly have three investment options:
- Equities (or stocks as they are often referred to)
The first guiding principle (accept the stock market is tough to beat) explains that the majority of fund managers don’t win over the long-term.
The second (understand risk and return are related) highlights that bonds are lower risk, defensive assets and that property and equities are higher risk, growth assets.
And our third (don’t put all your eggs in one basket) states that by diversifying appropriately, investors can reduce investment risk and potentially improve investment returns.
So why is focusing on the investment mix so important? Quite simply, it determines the types of returns an investor is likely to receive and how volatile the investment journey may be along the way.
According to various studies, the asset allocation decision (i.e. the focus on the investment mix) is the most important decision an investor can make. The flagship study that outlined this dated back to 1986 when Brinson, Beebower and Hood completed their white paper called ‘Determinants of Portfolio Performance’, which was published in the Financial Analysts Journal. They found that 93% of an investment portfolio’s performance is down to the asset allocation, and that only 5% of performance can be attributed to market timing or stock selection. The remining 2% was attributed to a wide band of ‘other’ factors.
Whilst this original research is 32 years old, the results remain appropriate today, as other studies have similar findings.
In 2002, then Chancellor Gordon Brown asked businessman and former Lloyds of London Chief Executive, Ron Sandler to complete a review of the medium and long-term savings industry. One of Sandler’s key findings was that “for the individual investor, the asset allocation decision is by far the most important factor in determining returns”.
Additionally, in January 2017 Vanguard Asset Management released their own research on this subject. They measured the performance of 743 balanced investment funds in the UK over a 25 year period from 1990 – 2015. They found that asset allocation accounted for 80.5% of the returns amongst the funds assessed. Vanguard also conducted the same research in the US, Australia, Japan and Canada and found similar results, with the US figure being as high as 90.1%!
Practically, what does this mean for the construction of an investment portfolio? The following chart provides some context:
Source: Dimensional Returns 2
From left to right, we have a ‘defensive portfolio’, a ‘balanced’ portfolio, and a ‘growth’ portfolio. The middle points of the lines are the long term expected averages of each strategy. As expected the defensive portfolio has the lowest figure at 4.1% and the growth portfolio has the highest expected long-term average at 8.6%.
The linear lines then highlight the possible range of returns of each investment strategy, i.e. the volatility. As you can see, the riskier the investment, the larger spread of investment return, both in terms of the potential upside and the potential downside.
To achieve the higher returns, an investor needs to be comfortable with this wider spread of investment returns and the volatility that comes with it. This is why the investment mix is such an important decision. If an investor gets this mix wrong and receives a loss they simply aren’t comfortable with, this usually leads to selling out of the investment and losing a lot of money, instead of waiting for the inevitable recovery of the value!
An investment portfolio needs to be structured in a way that achieves the returns an investor requires, without taking them to a place that would cause panic. This can only be determined by a thorough financial planning process, assessing an investor’s comfort, need and affordability to take risk, and then looking at how likely a successful outcome will be achieved based on differing investment conditions and risk profiles.
This is exactly what we do for our clients. Ensuring their money gives them the best chance of achieving their goals and objectives.
The value of investments and the income from them can go down as well as up, and you may get back less than you originally invested. Past performance is not a guide to the future. The investments described are not suitable for everyone. This content is not personalised investment advice, and Cooper Parry Wealth can take no responsibility for investment decisions you may make as a result of this information.