Asset allocation is the practice of deciding which assets to invest in, and where. It is driven by the need to diversify, one of the unshakeable mantras of investing. At Netwealth we allocate capital globally – to better protect wealth and to best position investors to achieve returns which meet their investment goals.
Asset allocation has long been considered one of the most important decisions an investor can make – it typically makes the biggest difference to investment returns. In broad terms, it is deciding which percentage of assets should be invested in stocks, bonds and other securities, and choosing on which sector or region to focus.
Why global asset allocation?
Investors should diversify chiefly because different assets perform better at different times. This is not only due to variations in how assets behave and prevailing valuations, but also in response to changes in expectations of the economy and how companies perform in future, and on account of geographic nuances.
At the highest level, shares may outperform one year, while bonds or other assets could do better the next. Therefore, a sensible portfolio should have a mix of assets, which will vary depending on the risk tolerance of the individual.
The challenge is that historic evidence shows it is difficult to predict when various factors will affect the returns of different asset classes, especially as markets often send conflicting signals for future performance. For instance, since the global financial crisis US stocks have shown stronger profitability than their European and Japanese counterparts.
However, as a result, this has made US stocks popular among investors, and significantly more expensive both relative to the other regions and to their own history. Given it’s hard to tell when markets will switch from favouring the growth of US companies to the cheaper stocks of Europe and Japan, it makes sense to maintain a broad exposure to them all.
Our approach to allocating capital
Our investment approach aims to give clients the best chance of meeting their investment goals.
Deciding the strategic mix of which assets to invest in over the long term will always be the main driver of our portfolio returns – and is designed to maximise returns for each client’s preferred level of risk by investing broadly, and internationally.
The range of assets we invest in is shown below and described in more detail here.
This list is not definitive, as we may invest in other areas if there is a clear benefit. All of our investments are subject to regular review.
- Cash and money market instruments
- Domestic and international government bonds, including inflation-linked issues
- Corporate and emerging market bonds
- Domestic and international developed market equities
- Emerging market equities
Steps in our asset allocation process
We explore our investment approach in detail here,
with a summary of the steps we take below.
- Before we invest, we use historical data as the starting point for expectations for how different asset classes may behave in future.
- Importantly, we then adjust them according to what is going on in today’s wider economy and market environment.
- We stress test how each asset may perform under different scenarios, with particular emphasis on how each risk level may be affected by changes in the relationship between assets.
- We decide which passive mutual fund or exchange traded fund (ETF) can best deliver the intended exposure of a given asset class or region.
- We analyse whether the current environment requires us to change the asset allocation of portfolios depending on shorter term concerns.
Of course, every step of the process is informed by the various risks that investments face such as market, portfolio and event risks. We urge investors to decide carefully which level of risk they are comfortable with, using the information and powerful tools we provide on our website, and to ask us if they require any further information or clarification. It is essential that investors recognise that the level of risk they choose will affect how their portfolio is constructed and hence the potential variation in returns they can expect in the future.
Avoiding the perils of home country bias
It is commonplace for investors to favour what they know, and to lean towards investing in the country where they live (through stocks or bonds). This bias – known as home country bias – can seriously affect the success of an investment strategy as it can result in less diversified, imbalanced portfolios.
Choosing where to invest and in what proportions for an overall portfolio is crucial but difficult – particularly when we see so much uncertainty in the world. Expertise, resources and experience help, which is why many investors use a service like Netwealth to ensure they are confidently diversified and to take care of the asset allocation challenge for them.
Please remember that when investing your capital is at risk.