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Using asset allocation to maximise return potential Back  
Shane Buckley outlines the potential for lowering investment risk and increasing returns by using an asset allocation strategy.
Asset allocation at its simplest means choosing the right international mix of cash, bonds, and equities (asset classes) in your portfolio which will enable you to reach your personal goal.

The asset classes you choose and how you weight your investment in each, will probably hinge on your investment time frame and how that matches with the risks and rewards of each asset class.

Equities: Equities have historically earned the highest returns of any asset class by a wide margin. They have however the highest levels of market risk (the risk that your investments’ value will decrease after you purchase them) over the short term.

Bonds: In general, these securities haven’t as much short-term price fluctuation as equities have, and therefore offer lower market risk. Historically, they have also had on average a lower rate of return.

Cash: This is the most stable of all asset classes in terms of return, and has a very low market risk. However, in the past, cash has also had the lowest average return of all asset classes.

The table entitled ‘Table 1’, shows the volatility of each class as measured by annual standard deviation over the same 20-year period. Equities have the highest volatility followed by bonds and then not surprisingly by cash. The table also shows the annualised average returns for each asset class and the best and worst performing years for each.

Equities are represented by the Standard & Poors 500. Bonds are represented by the Salomon 10 year Treasury index and cash is represented by the Salomon 3 month Bill index.

Before exploring just how you can get an asset allocation strategy to help meet your investment goals, you should first understand how diversification (the process of helping reduce risk by investing in several different types of asset classes) works hand in hand with asset allocation.

When you diversify your investments among more than one security, it helps reduce what is known as ‘single security risk’. This is the risk that your investment may fluctuate in value with the price of that one security. Diversifying among several asset classes increases the chance that, if and when the return of one investment is falling, the return of another in your portfolio may be rising. So with asset allocation, you are aiming to reduce the fluctuations in the value of your investments.

The table entitled ‘Sample Asset Allocations’, shows the asset allocation of several of the investment strategies offered by Irish Life International.

In the table entitled ‘Asset classes versus asset allocations’, we show the average annualised returns and the average annualised volatility for the different asset classes as well as for the sample asset allocations. It also highlights the highest and lowest returns for any calendar year during the 20-year period.

The performance figures for the strategies in ‘Asset classes versus asset allocations’ are calculated by creating a portfolio of the S&P500 (Equity), the US 10 year Treasury Bill (Bonds) and the US 3 month bill (Cash) in proportion to the asset allocation split shown in ‘Sample Asset Allocations’.

We can immediately see the benefits of diversification by comparing the US 10 year Treasury bill and the USD Medium Term Conservative (MTC) strategy. Over the 20 year period, the USD MTC strategy had a slightly higher average return of 0.1 per cent per year but the main benefit is the reduction in annual volatility from 8 per cent to 6 per cent. An investor can expect not only a higher return from the USD MTC strategy but also a substantially lower risk than a pure bond investor can. We can also see another benefit by looking at the worst performing years for each. The USD MTC strategy did not have a single negative return for any calendar year although the US 10-year Treasury bill fell 8.4 per cent in its worst year.

The USD Medium Term Growth strategy also shows the benefits of diversification. It had the same annual volatility as the US 10 year Treasury bill for the 20-year period but had on average a 1.6 per cent higher annual return of 11.6 per cent as compared to 10 per cent. This extra return is significant over a long-term horizon of 20 years with $373 extra return per $1000 invested.

By simply mixing asset classes, we can now see how an investor can increase expected return in their portfolio for the same level of expected risk or reduce risk for the same level of expected return. This demonstrates why it is always important for any investor to look on their investments as a portfolio rather than individual asset classes.

Asset allocation is a simple concept but vital to long-term investment success. For simplicity, I have kept the discussion to diversification between the different asset classes. International diversification refines the process even further. After deciding to invest in equities, an investor can spread their investment across many international equity markets. This provides more protection because when you invest in a number of different markets, you can lessen the effect of a decline in the value of one particular market. For example, in all of the Irish Life International strategies above, the equities proportion of the investment is actually spread across equity markets in the US, UK, Europe, Japan, Asia, Latin America and Eastern Europe in various proportions as determined by the investment manager.

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