The title could well refer to many aspects of life. For
example, does your lifestyle strike the right balance between
work, play and family? Do you maintain a balanced diet and
fitness regime? And so on. The subject of this column however
is personal finance so this issue’s topic will address
the question of having the right balance in personal assets.
Firstly, we should be aware of a premise that the experts
agree upon and which was neatly defined by Brinson, Singer
and Bebower in the Financial Analyst Journal, May –
June 1991.
‘Asset allocation constitutes the most important step
in portfolio construction, accounting for more than 90% of
the variability in portfolio performance over time.’
Prior to 2000 many investors believed the stock markets were
the only places to invest money. Easy to understand considering
that markets had been rising in double digit figures since
the early 80’s. Making money was so easy that many people
gave up their day jobs to play the stock markets and became
known as day traders. All that came to an end when the technology
bubble burst, bringing markets down across the globe for the
following three years. Even if you had employed the best stock
picker in the world there is little he could do when all sectors
were falling.
The emergence of Modern Portfolio Theory
The lost fortunes, the crippled pension schemes, the insurance
companies with depleted reserves all combined to force the
financial industry to rethink its strategies. They did not
need to go far since a Nobel prize-winning economist, Markovitz,
had already defined modern portfolio theory in the early 80’s.
The problem was that no-one listened to him because it was
so easy to make money in the stock markets. That is, until
March 2000!
Constructing a model portfolio
Today, modern portfolio theory is applied by leading wealth
managers, pension funds and financial advisers. Instead of
placing clients’ money into a simple split of say, 70%
equities and 30% bonds, a much wider range of assets is used.
Models have been developed for various levels of risk tolerance.
For example, the model for a conservative investor close to
retirement would be heavy in bonds and commercial property
funds but would be low on equities. Conversely, the model
for a young professional person would hold few bonds but would
have a large portion of international equities. Which model
would make the most money? Over time, the aggressive models
should, but they would be more volatile and could have negative
years that would be unacceptable to someone who is approaching
retirement or who is already retired. The ambitious investor
should also bear in mind that if an investment falls 50% it
will take a gain of 100% to bring it back to its original
value!
Example of a model strategic portfolio
A typical growth portfolio will look something like this for
a US Dollar based investor:
Domestic (=US Treasury) Bonds:
15%
International Bonds:
0%
Alternative Fixed Income (Corporate Bonds etc.):
5%
Domestic (=US) Equities:
30%
International Equities:
15%
Fund of Funds Hedge Funds:
20%
Commercial Property:
15%
____
Total:
100%
This asset allocation may be adjusted from year to year but
is unlikely to vary greatly from the above. The allocation
is designed for all market conditions and recognises the near
impossibility of market timing. The financial markets are
always full of surprises but the models are designed to minimise
the effect of those surprises over time.
How rigidly are the models applied?
It is recognised that there are investment opportunities that
could be missed by the models. We therefore adopt what is
known as a ‘core and satellite’ approach whereby
the model will comprise 80% of the portfolio and the remaining
20% will be in alternative, possibly higher risk funds. Examples
that have been successfully used recently include energy,
gold and precious metals, India and China. Next year the best
performing assets or areas may be entirely different. An investor
must understand that any portion of a portfolio that has the
potential to produce high returns also has the potential to
incur heavy losses!
What about cash and property?
This article has addressed only the medium and long term financial
asset part of a person’s total assets. The property
part of a model portfolio refers to funds that provide income
from rental of commercial properties as well as ground rents
and investments in student accommodation. It does not include
personal residential properties or land or property bought
as a personal investment. Neither do the models address liquid
cash holdings.
So what proportion of your total assets should be in property,
how much in cash and how much in financial assets? This is
an issue of considerable relevance to expatriates, particularly
in Bali. I will tell you what the experts say in the next
issue!
Colin Bloodworth is a senior adviser with Financial Partners
International. The opinions expressed are his own. If you
have any questions relating to personal finance you may contact
him at 021 520 8099 or colin.bloodworth@financial-partners.biz
