In the last issue of Spectrum, we highlighted the importance of having a plan around your investment assets, focusing on the importance of an investment policy statement (IPS). In an IPS, your unique circumstances and goals for your wealth are clarified and elaborated. It also addresses how the investment assets will be deployed — the mix of stocks, bonds, real estate and other assets the portfolio may hold over time to reach your goals. In the industry’s parlance, this is referred to as the asset allocation and it is well worth the significant attention given to it in the IPS.
Among the number of levers which influence portfolio returns, asset allocation is the most powerful. Each type of asset has different levels of risk and return and tends to be influenced by particular factors to different degrees. This means asset classes, and sub-classes for that matter, will behave differently over time — some will rise while others fall. Consequently, the assets the portfolio holds and the weighting each is given is the single largest contributor to overall performance. Highly-qualified researchers debate whether asset allocation contributes 40 to 100 percent of investment performance, but no one denies that it has the biggest influence on performance.
Setting the right allocation for every investor is both an art and a science. Your asset class exposure should be developed in the context of your unique circumstances and the goals for your wealth. The more specific you are with your objectives, the greater the chances are for a successful plan.
Rebalancing and Tactical Decisions
Other levers matter to overall performance, but to a smaller degree. For example, rebalancing a portfolio back towards its strategic targets and the timing of the rebalancing affects performance. Overtime, some assets in a portfolio will do particularly well while others will lag. The assets that do well will naturally increase in the weight of your portfolio such that your portfolio asset mix will move away from its intended levels. Restoring your portfolio to its original balance keeps it in line with your goals and risk tolerance. The rebalancing actions can be taken in light of tax circumstances and the advisor’s investment outlook, but it’s important to complete on a regular basis.
Tactical decisions, asset mix changes away from the strategic asset allocation, can also affect investment performance depending on the degree of latitude and process used to make those changes. Tactical decisions are taken to seek extra return within the portfolio’s target risk. Examples here may include adding more to assets that are undervalued and less to assets that are overvalued. It can also mean taking advantage of dislocations in markets such as distressed credit during the Great Recession. Market prices often move away from fair value due to overly optimistic or pessimistic expectations, investor risk appetite and market sentiment. Recognizing these windows of opportunity takes skill, and sometimes a little luck on timing, but nonetheless can result in added return.
Other Factors to Consider
Security selections within an asset class and portfolio construction are also factors in overall investment performance. There are many ways to approach security selection and portfolio construction. Also, diversification around investment philosophy and strategy also can provide better risk adjusted returns. We mention these to be complete. Remember, all in all, asset allocation is the biggest driver of your investment performance. Talk to your advisor about the tools they are using to meet your specific goals.
This article is for information purposes only and is not intended as an offer or solicitation, or as the basis for any contract to purchase or sell any security, or other instrument, or to enter into or arrange any type of transaction as a consequence of any information contained herein.
All analyses and projections depicted herein are for illustration only, and are not intended to be representations of performance or expected results. The results achieved by individual clients will vary and will depend on a number of factors including prevailing dividend yields, market liquidity, interest rate levels, market volatilities, and the client's expressed return and risk parameters at the time the service is initiated and during the term. Past performance is not a guarantee of future results.
Investors should seek financial advice regarding the appropriateness of investing in any securities, other investment or investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized.
The information and opinions in this article are presented as-is and may not be suitable for all readers. Please obtain appropriate advice for your particular situation.
©First Republic Investment Management, 2016