28 October 2014

Financial Markets and Asset Allocation

The past 10 years on sharemarkets has been an extremely interesting period to say the least. From 2003 to late 2007 we saw a very strong bull market followed by what became the second worst sharemarket crash since 1900, bottoming in 2009. To put it into perspective, it was worse than both the sharemarket crash of the Great Depression and the famous 1987 crash. Since 2009 we have slowly but surely seen a recovery in markets, with the Australian All Ords index (top 500 companies) now having recovered approximately three-quarters of its fall.

Given that this recovery has now actually happened, despite all the doom and gloom, it’s an important time to reflect because it tends to be human nature to want to buy when everyone else is buying (i.e. when everyone is feeling confident) and sell when everyone else is selling as panic sets in about markets potentially falling further. As a result it is easy to end up on the wrong side of financial markets and suffer losses, leaving a bad taste in your mouth. It tends to happen in sharemarkets more than in property markets given the liquidity of sharemarkets and the ease of buying and selling. This is particularly interesting given that the performance of both asset types over the longer term is very similar.

As illustrated in the charts below, we know that growth assets (shares and property) outperform cash and fixed interest over the longer term. So how do we benefit from this fact and avoid ending up on the wrong side of markets and suffering losses? The famous Warren Buffett puts it as simply as “being fearful (selling) when others are greedy and greedy (buying) when others are fearful.”

On the surface you might think "OK, well this is all easier said than done". But you can apply structure to your portfolio that actually assists you in achieving growth by applying asset allocation in the management of your portfolio. Of course, no structure is of any use unless discipline is applied to maintaining that structure.

Asset allocation is arguably one of the cornerstones to investment management.

As a result of the GFC and sharp falls in the sharemarket, you would have heard of some people being “wiped out by the sharemarket”. In fact, it’s not the sharemarket that wipes people out, but their allocation of assets to the sharemarket. The biggest issue leading into the GFC was that people became over-exposed to the sharemarket which resulted in panic and selling.

The objective of asset allocation is to design a portfolio that gives you an allocation to different asset classes that suits your investment objectives and life circumstances which, if followed correctly, puts you on the right side of markets; you reduce your exposure to markets when they are rising and buy as they are falling in order to maintain your asset allocation. Thus you achieve the Warren Buffett discipline of “being fearful (selling) when others are greedy and greedy (buying) when others are fearful.”

In successful investment management it is critical to understand that markets will do what markets will do and no one can accurately or constantly forecast the outcome of financial markets, let alone pick the tops and bottoms. There is, however, one thing that you can control and that is your asset allocation. That’s why asset allocation is one of the major cornerstones to successful investment management, enabling you stay on the right side of investment markets.




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