MOST investors understand that the long-term return on an investment portfolio hinges on the proportion of its assets that is allocated towards stocks, bonds and cash. But few give enough thought about having an allocation that is appropriate for their circumstances. In fact, many simply invest in a balanced fund and leave the decisions to the investment manager.
With the financial market facing a credit crunch and recession in the U.S., perhaps it is time to examine whether investors' assets are appropriately diversified among stocks, bonds and cash. However, a key problem with many financial institutions when they recommend an asset allocation strategy is that they don't delve further than an investor's willingness to take risks.
So if an investor says he is a conservative investor on the risk questionnaire that he is typically asked to fill, he is recommended a conservative asset allocation balance. Likewise, if he describes himself as an aggressive investor, he is presented with an aggressive asset allocation mix. These ready-made portfolios are created even before you have completed the risk questionnaire, and you are recommended the same portfolio as anyone who happens to fall into the same risk category.
Clearly, this method of determining a suitable asset allocation balance adds little value to the client. It only evaluates your willingness to take risks. What about your ability to take risks?
The difference here is that your willingness to take risks is dependent upon more subjective factors, like your attitude towards risk and return, and your personal behaviour when risk arises; whereas your ability to take risks is dependent on a number of objective factors, like your position in the investment cycle, your time horizon, your spending needs, your level of wealth, and your overall financial and risk management positions. The point here is that investors should look at both their willingness and ability to take risks before deciding on an asset allocation balance that's appropriate for them.
The weakness of relying on a strategic asset allocation (i.e. a fixed diversification between stocks, bonds and cash) alone is that it limits your ability to take advantage of better investment odds of one asset class over another that arise from time to time. This is where tactical asset allocation (market timing) is important. It involves shifts in allocations - relative to the strategic allocations - in an attempt to profit from the boom and bust cycles of different asset classes. For example, if it is expected that equity markets are going to under-perform, the investor would reduce the amount invested in equities and increase the amount invested in bonds or cash equivalents, such as money market funds.
But how can this be done when investing in unit trusts? The answer is simple: you can create your own asset allocation.
First, determine your ability and willingness to take risks. Then understand your asset allocation as to the percentage in bonds and equity. As for equity, you can choose single-country funds and sector funds to start with. But of course, you have to understand the economies of these countries and the sectors that you pick. This is where you need to predict which country and sector will outperform and which country will under-perform. If you are into bonds, then choose a global bond fund to act as a cushion should your equity funds fail to perform. Then you are in better control of your asset allocation. But if you are unsure about which country and sector, you can use global funds or regional funds as a substitute.
The next part is about selecting the appropriate securities within an asset class. This involves picking particular securities from all securities in an asset class, in the belief that they are worth more. Investors who deviate from their strategic asset allocation portfolios for tactical asset allocation or security selection reasons are "active" investors, and they manage active portfolios. However, security selection is not an issue when investing in unit trusts. The investment manager selects the stocks for you. All you need to do is to concentrate on the big picture (macro) and leave the stock (micro) selection to them.
After determining your willingness and ability to take risks, there is one final element to consider, and that is whether there is an actual need to take risks. Investors need to reconcile their willingness, ability and need to take risks when planning their investment strategies. Unit trust consultants have an important role in helping their clients understand that sometimes there is a need to be a bit brave and take a little more risk.
For example, consider a client who wants a rate of return of, say, 10 percent, but is not willing to maintain an aggressive enough investment portfolio to achieve that return. If he invested purely on the basis of his unwillingness to take risks, he will probably not achieve his financial goals. A good unit trust consultant should be able to determine if his client can take more risks and then help him to understand the need to do so in order to meet his targets.
Balanced funds will serve you well if you are a passive investor content to leave asset allocation decisions to your fund manager. In conclusion, it is probably better to take the time to understand.
* The views expressed belong solely to the writer.