Asset allocation: the decision that matters most

Research on portfolio outcomes has consistently found that the allocation between broad asset classes explains the large majority of the variation in returns over time, considerably more than security selection or timing.

The main asset classes

What they do.

Equities: ownership of companies, with the highest long-run expected returns and the largest falls.

They are the growth engine of most portfolios and the source of most of the discomfort.

Bonds: lending to governments and companies, with lower expected returns and, historically, lower volatility.

Government bonds of high-quality issuers have historically provided some ballast during equity falls, though the relationship is not reliable in every environment — as recent periods have demonstrated.

Cash: certainty of nominal amount, erosion by inflation, and the role of covering short-term needs.

Property, whether directly or through listed vehicles, with its own characteristics and liquidity considerations.

And various other classes — commodities, infrastructure, alternatives — which serve specific purposes and are not necessary for a sound portfolio.

What determines your allocation

Three things, none of them forecasts.

Time horizon: money needed sooner requires less volatility, since there is no time to recover from a fall.

Capacity for loss: what would actually happen to your life if the portfolio fell substantially — which is a different question from how you feel about risk.

Tolerance for volatility: whether you would sell after a large fall, which is the question that matters most because selling after a fall converts a temporary decline into a permanent loss.

The appropriate allocation is the most aggressive one you could hold through a bad period without selling, which is generally more conservative than a questionnaire suggests.

Rules of thumb and their limits

Which are starting points rather than answers.

Age-based rules — holding a bond percentage related to age — are crude and have some intuitive logic in reducing risk as the horizon shortens.

They ignore capacity for loss, other income sources, guaranteed pensions, health and individual circumstances.

Target-date and lifestyle funds automate a glide path towards lower risk, which is convenient and assumes a retirement date and a way of taking the money that may not apply to you.

Which makes them a reasonable default and a poor substitute for thinking about your own position.

Diversification within asset classes

Which matters alongside the split between them.

Geographic diversification, since concentration in one country exposes you to that country's specific fortunes.

Home bias is common everywhere and is a deliberate choice worth making consciously.

Sector diversification, which market-cap indices provide automatically and which becomes concentrated when a few sectors dominate.

Company size, where broad indices include large, medium and small.

And within bonds: issuer, credit quality and duration, which behave very differently.

Rebalancing

The mechanism that maintains the allocation.

Over time, the better-performing asset class grows as a proportion of the portfolio, which increases risk beyond what was intended.

Rebalancing sells some of what has risen and buys what has not, restoring the target.

Which is psychologically uncomfortable — it means selling the thing that has done well — and which is the discipline that maintains the risk level.

Approaches include calendar rebalancing at a set interval and threshold rebalancing when an allocation drifts by a defined amount, and the evidence does not strongly favour either.

Rebalancing with new contributions, rather than by selling, avoids transaction costs and tax consequences and is generally preferable while contributing.

What allocation is not

Worth stating.

It is not a forecast about which asset class will do better.

It is not something to change in response to news, which is where most damage occurs.

It is not the same as diversification, though diversification is part of it.

And it is not permanent — it should change as circumstances and horizon change, on a planned basis rather than a reactive one.

Getting it wrong in the two directions

Both are costly.

Too aggressive: selling after a fall, which crystallises losses and frequently produces years out of the market.

Too cautious: a portfolio that does not grow enough to meet the objective, which is a slower and less visible failure and which affects a great many long-horizon investors holding too much cash.

The second is under-recognised because it produces no dramatic moment, only a shortfall decades later.

General information only, not investment advice. Investments can fall in value and past performance does not indicate future returns. Consult a regulated financial adviser.