Most investors want steady returns, however our world serves up booms and busts, volatility and crises. So, how does the rational investor manage this environment? The answer is to focus on those things within our control. This is where strategic asset allocation is so powerful.
What is Strategic Asset allocation?
It is an approach to building a long-term portfolio by blending various asset classes with different risk and return characteristics. This type of allocation is done with the goal of generating maximum returns within acceptable risk parameters.
We have precise data on how markets have performed in every developed economy for the last 100 years. This gives us an enormous amount of information on which to base our investment decisions. For instance, we know that equity markets in South Africa, the USA and Europe have all shown similar returns of approximately 6% per annum above their inflation rates in the long run.
We use this information on equities, cash, bonds, property and offshore asset classes when formulating the ideal asset allocation for a client’s risk and return appetite. In other words, the data about the historical returns and volatility of each type of asset allows us to model the most likely outcomes for the future.
In a diversified portfolio over 85% of your returns are derived from the asset allocation, and only a small percentage comes from factors such as stock selection
In the chart below we can see this in action. We know that equities are the strongest growth assets, but they can also be volatile. So, we allocate more equities to those funds which require higher returns and are suited for longer investment horizons. Similarly, we see that lower risk funds which target lower returns will have higher allocations of cash and bonds.
Let’s compare this to baking a cake. You have to include the correct ingredients to make the cake you want. If you don’t include cocoa, then it won’t be a chocolate cake. With investing, many people want certain outcomes, but they are not familiar with the ‘ingredients’ - the asset classes, that must be included in their portfolios to achieve the returns they seek with the lowest possible risks.
Strategic asset allocation is a foundational investment strategy for long-term investors and while it may not be the most exciting, it offers numerous advantages. It enables investors to diversify their portfolio rather than place all their eggs in one basket, and as we know, diversification minimises the risk of loss if one asset class underperforms over a certain period.
The mix of investments selected using this strategy does not change with the markets, which means you’re not constantly worried about changing your portfolio through peaks and troughs. What’s more, strategic allocation rebalances portfolios to target weights at a pre-specified period so there are no surprises.
This type of investing strategy is ideal for investors who want to achieve inflation beating returns over the long run, rather than chasing the market. They can also go to bed at night knowing that their investment decisions are not being dictated by herd mentality or speculation. In summary, strategic asset allocation is essential for retirement planning.
Disciplined asset allocation and regular rebalancing is the recipe for successful investing