BlackRock (the world’s largest asset manager with US$8.7tn of assets) has reported that 94% of portfolio returns are generated by creating the right asset allocation. In contrast, only 6% of returns are generated by active stock picking and market timing. In other words, stock picking is essentially meaningless and asset allocation drives all of the value.
Fortunately, setting up a winning asset allocation is remarkably straight forward. It doesn’t require a PHD in financial analysis, and it can actually be explained in a 650 word blog… so here goes!
Long-term investing just got longer
Keynes famously said that “in the long-run we are all dead”. This is clearly true and no-one can (yet!) successfully argue against it. However... because of our ever increasing life expectancy, if we wanted to, we could decide to argue about it for longer and longer than any generation ever before us...
This is important because understanding asset allocation can essentially be unpicked by understanding one key fact: Time is your secret weapon.
Why is this the case? Well, despite the incredible long-term returns delivered from investing in stock markets, they’re actually very volatile in the short-term. The downside of this is obvious - you can’t expect to invest in the stock market for just a short period of time and to generate high returns. Instead, however, all you need is enough time to ride through the short term ups and downs (i.e. the short-term ‘volatility’) in order to benefit from those incredible, long-term upward trends.
All you need is
Traditionally, the way to manage this short-term risk or ‘volatility’ was by diversifying into lower risk products (e.g. bonds) - i.e. to shift your asset allocation away from equities and into bonds. The problem with this strategy, however, is that these products with lower risks also have lower long-term returns. And so this traditional ‘asset diversification’ strategy means that you end up having to sacrifice higher returns in order to manage this volatility risk in the short-term. You therefore had to choose between either ‘lower risk & lower returns’ or ‘higher risk & higher returns’. You couldn’t have your cake and eat it.
With time on your side, however, you can now avoid having to make this trade-off. You don’t need to diversify into lower risk / lower return products in order to manage the short-term volatility risk. Instead, with time, you can just ride it out. This is the magical part of long-term investing - by using time as a tool to diversify the short-term volatility risk, it means that you can manage this risk and yet not have to sacrifice higher long-term returns. Time is your secret weapon. By using time, you can actually have your cake and eat it - you can achieve higher returns with lower risk.
If you're saving for a goal, then by definition you'll eventually run out of time...
An optimal asset allocation for long-term investing therefore means that you can have high exposure to equity markets, and you don’t need to diversify your assets heavily into bonds in order to protect yourself from short-term volatility. Time is your secret weapon to counter volatility.
Eventually, however, your investment plan will approach the goal that you’ve been targeting. As this happens, by definition, your remaining time in the market will be relatively short. Only at this point, then, do you have a need for a diversified asset allocation. This is because asset diversification is a useful tool to help you ‘lock-in’ the long-term investment returns that you’ve already captured, when time isn’t on your side. Asset diversification is therefore a tool to protect your previous investment gains from short-term losses, not a tool to generate those high returns in the first place.
Give me that PHD in financial analysis
As such, setting up a winning asset allocation strategy just means maximising your higher-risk exposure in the long-term (i.e. equities) and adjusting to lower-risk assets in the short-term (i.e. bonds) as you approach your goal. It’s as simple as that.
The important question is: What is defined as long-term and what is short-term? This is similar to the question of how long is a piece of string... but a general rule of thumb is 5-years; Longer than 5 years can be considered long-term and shorter than 5-years can be considered short-term.
And that’s it. You can now claim your PHD...