The spinning wheel
4 Aug 08
If investment is a gamble, advisers can make the outcome more predictable and less risky by careful balancing of asset classes
by Graeme Lind
Accountants, and other professional advisers, need to be very careful about whom they refer their clients to for investment advice. They must ensure that the approach adopted by the adviser meets the requirements and risk profile of their client.
If the client is offered an inappropriate investment strategy, and as a result suffers losses, this could potentially damage the client relationship with the accountant.
For the vast majority of clients the first priority is the preservation of their wealth. This must be reflected in the approach adopted and the most effective way to achieve this is to manage investment risk through an appropriate asset allocation strategy.
The basics
The performance of any investment portfolio is determined by a combination of factors.
• The mix of asset classes
For example, how much is held in equities, fixed interest, commercial property, cash and other asset classes.
• The choice of investments in a class
Which particular companies or funds are invested in.
• Timing
When a particular investment or asset class is bought or sold.
The overwhelming majority of studies show that differences in investment returns are almost entirely driven by asset allocation and when allocation decisions are taken.
This article examines the approach that professionals’ clients should adopt.
Predicting the future
How often have you seen “experts” predicting which investment classes will perform well and which will perform badly? Some use a vast array of data to come to their conclusions while others use little more than guesswork.
However, the track record of forecasters is far from convincing. Renowned economist JK Galbraith summed this up nicely when he said: “We have two classes of forecasters; those who don’t know and those who don’t know they don’t know.” Unfortunately a poor track record does not stop many in the financial services industry from continuing to try and predict what is going to happen.
To take a recent example, what are the chances that your clients increased their equity weightings in the 1990s and then came out of shares just before the market crash at the beginning of the millennium? The former may be possible, because when markets are rising investors and advisers are usually bullish, but the latter is very unlikely. At the beginning of 2000, the industry consensus was very positive toward equities and, after their phenomenal growth, to technology stocks in particular.
In March 2003 as stock markets bottomed, the mood was doom and gloom and very few people increased their equity weightings. Indeed, many were still coming out of equities, crystallising their losses, and investing in areas such as cash and fixed interest.
Good investment periods often follow sharp falls, when most people are put off equities. From the bottom of the market in 2003, over the next nine days there was a rise of 18 per cent – about 40 per cent of the total rise into the summer of 2004.
While this example relates solely to shares, the same is often true of other asset classes.
Nobody can predict the future with any accuracy and once clients accept that, they should aim to position their portfolio so that whatever the outcome, they have the best chance of meeting their financial objectives.
Understanding risks
It is essential that your clients understand investment risk. They may have considered their tolerance to risk in the past, and could have put themselves between three and five on a scale of 10, but what does that mean and how can it be used when constructing and managing an investment portfolio?
Risk is subjective, and individuals’ attitudes to it vary depending on how their investments are performing. When they are doing well there is a tendency to play down the risks and when they are performing poorly, to assume them to be much greater than they are.
It is much easier to quantify risk if you have some financial parameters to work within. For example, if a client knows that the maximum return over a given period is likely to be X and the maximum loss is likely to be Y, they can quickly determine whether this fits their investment expectations and risk tolerance.
Most of us accept that to achieve higher returns you need to take some risk. However, more risk does not automatically mean higher returns. The challenge is to balance risk with potential to reward the client.
While a cautious investor may favour more in cash and fixed-interest securities, they could improve the prospects for longer-term returns, and reduce the risk of relying on fewer asset classes, by investing in commercial property and equities as well, in the right proportions.
On the other hand, an aggressive investor should hold cash for liquidity and could benefit from the diversification offered by fixed interest securities and commercial property.
By focusing on risk, particularly on managing it, it is possible to reduce highs and lows associated with investing and achieve more consistent returns with fewer sleepless nights.
Understanding rewards
It is often said that greed or fear dictate investment decisions, and there is plenty of evidence to support this.
Short-term past performance figures can be seductive. During the middle to late nineties the UK stock market rose significantly with the top performing funds proving very popular. This culminated in investors flocking into technology stocks. Prices soared under the weight of new money and the feel-good factor, before the bubble burst and shares fell sharply. Many people joined this bandwagon late, believing there were easy rewards to be made and not wanting to miss out.
At other times perceived wisdom dictated that shares were high risk and poor value and that residential property and buy-to-let were secure assets with healthy prospects for future gains. This happened in the late 1980s and early 1990s when a property slump followed a boom and the signs are that it is happening again.
In more recent years, investors have looked at China, India, Russia and Brazil, regions that have performed astonishingly well and as a result attracted huge amounts of money. Again many investors may be trying to make easy money without fully appreciating the risks.
The best way to avoid boom and bust is to make objective decisions that ignore investment fashions. It is important to take a long-term view of how assets perform without being dictated by short-term sentiment.
Asset class correlation
Whilst we cannot predict the future performance of asset classes, we can see that over the long term asset classes can relate to each other in predictable ways. For example, the price of property in the UK bears little resemblance to movements on the London Stock Exchange, but share prices in London often mirror those in New York, Paris and Frankfurt.
Correlation, or lack of it, is important because it affects the diversification and volatility of portfolios. If clients just held UK and US shares, a market fall in the United States is likely to take the whole portfolio down. However, if they added commercial property, fixed interest and Japanese equities, which correlate less closely with western markets, the portfolio would be better diversified.
By understanding the strength of these relationships, assets can be blended to reduce risk and, in many cases, improve potential returns. It is important, however, that all selected asset classes have the potential to reward the client in the long term and are not unduly prohibitive in terms of costs, liquidity or other characteristics.
Achieving the right mix
To fully benefit from the lack of correlation between different assets is not as easy as just holding a range of different investments. It is important that these investments are held in the right proportions so quantitative techniques need to be employed.
The objective is to construct investment portfolios that have the maximum expected return for a given level of risk or the minimum level of risk for a given level of expected return. This approach is said to describe the mean-variance efficient frontier and was developed by Harry Markowitz.
The work of Markowitz is still revered today but he had no computers to do the masses of analytical work that would have made his theory more robust. Markowitz had to suppose that any assumptions he made were 100 per cent accurate, which could never be the case.
Today, using computers and a process called re-sampling. many different outcomes are produced. These are averaged to produce the optimum blend of assets for a given level of risk or return.
The result is an investment mix that tends to be more diversified than traditional portfolios with less emphasis on specific asset classes and portfolios that are proven to be effective at managing risk and enhancing investment value.
Conclusion
The key to good client relations is to meet, and exceed, expectations. This is extremely important to professional services, advisers and should be a major consideration when referring third parties to work for their clients.
This is never more important than in investment management. Levels of service or attention to detail can sometimes be quite subjective, whereas the amount of money that clients’ portfolios have made or lost is a matter of fact. Professional advisers therefore need to ensure that when they recommend the services of investment managers, they are confident that the managers can meet and exceed the requirements of the client.
This is far more likely where the investment manager has a full understanding of, and is effectively striking the right balance between, the return the client is hoping to achieve and the risk they are prepared to take.
Graeme Lind is a wealth adviser with financial advisers Towry Law, based in Edinburgh.