UK: Investment planning - Using asset allocation to balance risk and return

Last Updated: 7 June 2005
Article by Stuart Davies

Most Read Contributor in UK, August 2017

Asset allocation is the process of dividing a portfolio between major asset classes such as bonds, equities and cash. These major asset classes can, in turn, be subdivided and, in the case of equity markets, the decision as to how much to allocate between particular equity markets would also form part of an asset allocation decision.

At Deloitte, our focus is on strategic asset allocation. This involves a long-term commitment (typically more than five years) to investing in the standard asset classes of bonds, equities and cash. By adopting a strategic asset allocation methodology, we help potential investors diversify their investments among asset classes, with a view to achieving their previously established goals. As we add more asset classes, such as hedge funds and property, we can add flexibility to expected risk and return levels within the portfolio.

The importance of asset allocation

Nearly all academic studies show that strategic asset allocation is the most important determinant of how a portfolio performs over time. It is a technique that factors in the risk of each asset class (portfolio volatility). If an investor is not concerned about risk, they are probably not interested in diversifying between asset classes. However, in our experience, most investors care very much about risk and wish to make sure they have enough money available to meet long-term financial objectives. Therefore, strategic asset allocation is very important in any investment planning process.

The results of a study by the academics, Brinson, Beebower and Hood, show the relative importance of components of portfolio performance over time.

Return component %
Strategic asset allocation 91.5

Market timing

1.8

Security selection

4.6
Other factors 2.1
Source: Ibbotson Associates
 

Return component

By modelling the expected return and volatility of each asset class, together with the correlations between each pair of asset classes, it is possible to determine the most efficient asset allocation for any portfolio, given a particular level of risk. By efficient, we mean that there is no other combination of asset classes that is expected to give a higher level of return for the given level of risk, and vice versa.

Expected returns and correlations between asset classes are based on historic data, which of course may not be a reliable guide to the future. As with all investment planning techniques, there is no guarantee of the results.

The efficient frontier

For any rational investor, their chosen portfolio should sit on the efficient frontier, with the precise position a function of their risk tolerance. This position then determines the appropriate individual asset allocation.

In choosing their preferred position on the efficient frontier, the most important factor that an investor should consider is the risk versus return trade-off.

The risk vs. return trade-off

The ‘risk versus return’ trade-off determines what constitutes an investor’s optimum portfolio. Any rational investor will wish to achieve the highest possible return. However, simply choosing the assets with the highest potential return is not necessarily the most prudent decision.

While the gains might be significant in bull markets, the losses in bear markets might easily equal, if not exceed, these potential gains. What separates ‘returnhungry’ investors from satisfied ones is the ability to weigh the difference between risk and return.

Conclusion

Our aim is to help clients preserve the value of their wealth in real terms (after the negative effects of inflation). Investors require specific individual solutions because their investment objectives and risk tolerance are unlikely to be identical to those of anyone else. We work closely with clients to ascertain their individual risk tolerance and then construct investment strategies which meet their investment objectives.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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