FOOL'S EYE VIEW
The Asset Allocation Dilemma

By Maynard Paton (TMFMayn)
July 19, 2002

The question of "asset allocation" is as old as the hills. It can arise when you have a large lump sum to invest. What proportion of the money do you allocate to ordinary shares? How much should I leave in the bank? What about gilts? Should I diversify into property? Is gold worth investing in too? And so on.

Opinions will obviously differ. But if you ask me, I'd say, for novices, keep to the mainstream (i.e. an index tracker or a blue-chip portfolio equivalent, gilts and cash) and forget all about the esoteric options (e.g. penny shares, hedge funds, split capital investment trusts, precious metals, buy-to-let). In my view, the more specialised an "asset class" is, the more chance of it doing some harm to your wallet. For beginners at least, it's best to stick to the beaten track.

So, with just (a diverse set of) shares, cash and gilts in mind, how should a novice investor split, say, a lump sum? Unfortunately, there's no simple answer. While many financial pundits will express something along the lines of...

"Ideally, you'd want to be 50% in shares, 30% in gilts and 20% in cash, although if the stock market turns nasty, you should reduce your share exposure to 30%, while increasing gilts and cash to 40% and 30% respectively..."

... investing life just ain't that simple.

You see, every person has their own individual tolerance to stock market volatility. Everybody has their own personal financial circumstances too. All of this makes any "one asset allocation guide fits all" statement virtually useless.

Volatility

While traditionally rewarding, investing in shares courts risk. Although history has shown that, over the long-term, shares have outperformed cash and gilts, there's always the danger of prolonged periods of future equity underperformance.

With that risk-reward dilemma in mind, is there a risk-adjusted analysis that can devise the optimum equity, cash and gilt weightings for a portfolio? Indeed there is, courtesy of the CSFB Equity-Gilt Study.

Using data from the last thirty years, the ideal risk-adjusted portfolio for the investor with an "average risk tolerance" is 50.8% shares, 49.2% cash and 0% gilts. (According to CSFB, gilts fare badly as they have roughly returned the same as cash over time, but carried significantly more volatility.) 

Trouble is, CSFB's findings are not particularly useful for the ordinary private investor. Firstly, how do you know if your "risk tolerance" is average? And secondly, their general conclusion is, unsurprisingly, that the weighting of equities in your portfolio should be generally proportional to your "risk appetite" (however you define that!).

Circumstances

Of course, such mathematical studies don't take individual circumstances and preferences into account. If you feel you need a substantial emergency fund, or require a fixed amount for a specific event, then having most of your cash tied up in shares is perhaps not a good idea.

What's more, precise weightings from the CFSB and others are fine in theory, but just plain impractical in reality. At what point do you trim any imbalances? And do you adjust the weightings in light of the latest historical data? It can all get terribly complicated.

No answer

So, what's the best way of dividing up your savings and investments and resolve the asset allocation conundrum? As mentioned earlier, there's no simple answer. In fact, there's no answer at all. Instead, there's a set of Foolish guidelines that can help each individual make their own decision:

Remember:

* Evaluate your own financial circumstances and investing aims (have you had your Financial Health Check?);
* Shares have historically outperformed cash and gilts by a wide margin;
* "One size fits all" financial advice is almost certain to be useless, and;
* Experience, common sense and comfort are your best friends when investing.

It's vital to note that there are no rights and wrongs in how you divide up your savings and investments. The fact that you have put all your money in an index tracker, in the bank or in property, or split the money between several different types of investment class, is not important. What is important, though, is knowing whatever decision feels right to you, is in fact the right decision.

More: The Risks of Age | How to Build A Long-Term Portfolio | Discover how Shares Have Historically Outperformed Cash and Gilts

A version of this article was published in August 2001.