Asset allocation requires a regular rebalancing act

Philip Salter
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ALLOCATING assets is a complicated science or skilled art with debated influence on actual returns, but it remains the best place to start.

Modern portfolio theory is rooted in the 1952 work of Nobel Prize winner Harry Markowitz. His work heralded a revolution in investing. Morningstar’s quantitative research director Paul D. Kaplan and Stanford University’s Sam Savage note that in the same way the Wright brothers pioneered powered flight in 1903, conquering the three axes of control – pitch, yaw, and roll – Markowitz got to grips with asset allocation through weighing up risk, reward and correlation.

However, following the crash in asset valuations in 2008 across the world, Markowitz and his legacy have come in for some criticism. The critiques are fair, but aren’t the death-knell of trying to theorise and quantify the allocation of assets. Kaplan and Savage put its failure down to the “flaw of averages” used in the mean-variance model. To overcome this, they have developed a scenario-based approach that tries to account for the fat tail risks, explored at more length in Kaplan’s forthcoming book The Importance of Asset Allocation.

A truism has developed that asset allocation accounts for around 90 per cent of variability, based on Determinants of Portfolio Performance (Brinson, Hood and Beebower, 1986). If only this were so. As Roger G. Ibbotson in The Importance of Asset Allocation shows, subsequent scholarship questions this number. Ibbotson believes active management has about the same impact on performance as a fund’s specific asset allocation policy. Matt Hoggarth of Thesis notes “a large part of the return comes from the decision to invest in risky assets at all.” He says “if you look at returns compared to a market benchmark then contributions by asset allocation and stock selection are more evenly balanced, and together only explain about 40 per cent of the total return.”

Even though asset allocation probably isn’t the linchpin posited by many, it is still an important component of investing that cannot be ignored. Kaplan has contributed to questioning its 90 per cent weighting, but still says investors should begin asset strategy by looking at asset allocation.

Whatever the actual importance of asset allocation, investors should know where their wealth resides and rebalance to align strategy with their risk appetite. Also, current market conditions shouldn’t necessarily impact upon your long-term strategy. Jason Witcombe of Evolve believes: “If before the Eurozone crisis an 80 per cent equity and 20 per cent fixed interest portfolio was right for you in terms of your long-term financial aspirations and return requirements, it should still be right for you.” Andrew Swallow of Swallow Financial Planning agrees: “We recommend the same asset structures now as we would do in a raging bull market. All that changes is the rebalancing at the end of each year.” However, Tony Gammon of Thesis says they have reduced equity weighting over the last few months in the face of the Eurozone crisis, although he stresses the need to reflect a client’s risk tolerances and time horizon.