We all know we need to diversify our assets -- but few of us get round to it.
I've been thinking a lot about asset allocation over the last few months. Yet so far, I've done almost nothing about it.
And in that, I don't think I'm alone. Asset allocation, it seems to me, is one of those dull-but-worthy aspects of investing that many of us put to one side, or, if we address it at all, do so very simplistically. In my case, that means parking part of my SIPP in an oil fund, a mining fund, and a low-cost Asia Pacific index tracker. So despite some sector and geographic diversification (and ignoring a small emergency fund), I'm 100% equities. Stupid, or what?
The lure of shares
But it's easy to see how this state of affairs comes about. You join The Fool, read the interesting stuff about shares and index trackers, and start investing. And pretty soon, you've got a decent-sized holding.
At which point, I'm willing to bet, it's very likely that your wealth will comprise just three asset classes: equities (either as trackers or shares); cash (in ISAs or other savings accounts); and property (if you've bought a house or flat).
Ignoring property, I'd also bet that huge numbers of people went into the present downturn with far more money tied up in equities than they now think is sensible, and with rather too little cash. As I've remarked here before, I know that I did.
Yet again, you can see how this comes about. Here at the Fool, the message has been loud and clear: over time, equities vastly outperform cash. And again and again, research such as the Barclays Capital Equity Gilt Study consistently confirms this.
The 2009 version of the study, for example, examines 109 years of history and shows that in rolling five-year periods over those 109 years, shares outperformed cash 74% of the time. Over rolling 10-year periods, shares beat cash 92% of the time, and over rolling 18-year periods, shares beat cash a stunning 99% of the time. So where are smart investors going to put their money? Shares, of course.
Gilts and bonds
But cash isn't the only alternative asset class. In addition to property, investors can choose to buy corporate bonds, and gilts -- which are bonds issued by the government. (Of course, they can also put their money into rare stamps, fine wines and other exotica, but we'll ignore that for the time being.)
And time and again, we're told that bonds and gilts are A Good Thing. Here on this very site -- and today, as it happens -- we read some sensible words of advice. "As you get closer to retirement, more of your assets should be in fixed‑income investments like gilts and bonds," says the author, a Foolish writer whose articles I very much enjoy.
But how many of us have actually bought a corporate bond? Or government gilt? I know I haven't. Equally, though, I know that I should.
And -- even more damningly -- how many of us even know how to buy a corporate bond or gilt? I've got a pretty good idea, but that's not to say that I might not be somewhat off the mark.
Now, as that same Barclays Capital Equity Gilt Study shows, shares also outperform bonds and gilts -- but by nowhere near as much. More to the point, bonds and gilts experience less extreme fluctuations in valuation, and those fluctuations are often inversely correlated -- meaning that when one asset class goes down, the other very handily goes up. Which contrasts very favourably with my own investment performance so far this recession.
Superior returns
But there's more to properly thought-through asset allocation than simply minimising risk -- and losses -- through diversification. Just as we hear a lot about investors such as Warren Buffett and Peter Lynch, expect to hear more of the superior returns achieved by David Swensen, the investment manager at American university Yale, who has managed its enormous endowment fund for almost a quarter of a century.
By carefully following the principles of asset allocation, Swensen had managed by 2006 to achieve an average return of 16% a year -- for 21 years. That's some going. His formula? A mix of American shares, shares in other developed economies, emerging markets, property, bonds, and gilts.
Asset allocation -- dull-but-worthy? Not with returns like that, which have been enough to persuade me to actually do something about asset allocation. Next week, in a follow-up article, I'll look at how to decide how much of your portfolio should be in equities versus other asset classes. And, for the curious, I'll also look at how to go about buying bonds and gilts.
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