Multi-assetMar 22 2012

A benchmark to fix against

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ByChristopher Mahon

For most investors, asset allocation is the single most important investing tool at their fingertips.

A decision on whether to have 30 per cent or 70 per cent in stocks can make or break a portfolio. Tactical or strategic changes can make a huge difference either way.

Dealing with the risks of getting it wrong yet allowing returns to flourish is the art of asset allocation. Balancing risks and returns means looking at the margin of safety on offer and being disciplined before taking any decision.

Strangely this simple idea – to see how much room for error is on offer - is frequently discarded. Instead many people fall into the trap of conflating risk with rewards.

But risk does not equal return. Good asset allocation needs to get to grips with both.

Many investors focus only return and never think about risks. Phrases such as “with cash at zero, even a few per cent a year has to be worth something” betray this type of thinking. If you ever hear your investment manager utter these words, take your money elsewhere.

A simple example: “Emerging market equities are risky” – that much many people will acknowledge. But many investors will go on to believe that emerging markets are more likely to yield high returns – irrespective of the valuations on offer. The margin of safety is ignored.

Distinguishing risk from return is important at every stage of the asset allocation process. For successful multi-asset investing it starts with the area investors probably think about least: their benchmark.

Multi-asset benchmarks (like a 60:40 equity / bond split) are a perfectly reasonable idea. But left unchanged for years (as they often are) they will come to dominate performance. Investors need to think – and not accept the status quo.

For example and contrary to popular belief, it is not true that someone with a “high risk/return tolerance” consistently warrants at most times a higher allocation to either risky equities or emerging markets. Riskier behaviour does not typically equate to a greater likelihood of success. Higher returns can come from lower risk areas, even over a long period of time. Ask anyone who invested in equities in 2000.

With multi-asset benchmarks often being left unchanged for years this can be source of woe. Having 60 per cent of your benchmark in equities is great when equities are cheap. By contrast when equities are expensive it could be detrimental to use a benchmark with the bulk of the risk in that asset class.

The bottom line is that with multi-asset benchmarks, the benchmark is the main source of risk. Choosing one is often rushed and the decision rarely re-assessed in a proactive manner.