The concept of multi-asset investing is not new, based as it is on allocating across various asset classes, such as equities, fixed income, property, commodities and alternative investments, in order to generate a particular return.
"Governments rarely go out of business"
The higher the return you want from your investments over a particular period, the more short-term volatility you have to accept in the value of your investments. So, if you’re happy to receive the bank deposit rate, you can put all your money in the bank, safe in the knowledge that the account balance is not going to fluctuate, but will rise a very small amount every day. In other words, not only will you achieve your desired rate of return over a year but you’ll also receive it each and every day. However, if you want higher returns, you’ll have to look beyond bank deposits to other investments.
These investments may include fixed income, where the investor lends money to a borrower (the bond ‘issuer’) in exchange for regular payments at a set interest rate and repayment of the loan at the end of the term; equities, where the investor owns a share in a company and enjoys profits (or suffers losses) based on the company’s performance; commodities, which involves investing in raw materials, including precious metals such as gold; property, where investors can either buy property shares, or actually become owners of a physical building; and alternative investments, an incredibly diverse area which includes investments such as hedge funds (funds which use specialist techniques to extract returns between financial instruments and markets) and private equity (where the shares that the investor owns are not quoted on an exchange). Each of these investments offers different characteristics and varying potential levels of return.
Accepting short-term volatility for higher returns
Let’s look at equities as an example of why some investments offer higher returns than bank deposits. An equity is a slice of a company and so its return over a particular period is the change in its price (which could be positive or negative) plus any dividend received. Dividends are paid out of profits, which are what’s left from revenues after everyone else has been paid (eg employees, suppliers etc.) Revenues are unpredictable because there is uncertainty around how much of its product a company is going to sell in the future. Costs can either be fairly certain (employees’ salaries are known in advance) or uncertain (raw material prices may be volatile).
That’s why profits can fluctuate enormously from year to year. Because profits are uncertain, owners of equities require a greater return than they would accept from bank deposits. What investors are implicitly saying when they buy equities is either “I want a higher return but understand that I have to accept volatility in returns over the short term” or “Because returns over the short term are volatile, I need my longer-term return to be higher.”
These statements look at return from different perspectives but effectively say the same thing.
Looking at risk from a longer-term perspective
Astute readers may have noticed that no mention has yet been made of “risk”. But what is risk? Intuitively, risk is the possibility or probability of loss. But if you’re talking about one of those frequent falls in a share price on a particular day, is that really an important loss? First, it’s only a loss if you sell the investment. Second, most of the time these “losses” are temporary, and prices soon bounce back. The reason this is important is that, in its wisdom, the financial industry has defined the risk of a particular asset as the extent to which its price fluctuates; in other words, risk is the likelihood of an asset not achieving its long-term expected return over a short period.
Perhaps the risk that investors should really care about is the possibility of an asset not achieving its expected return over the long term, rather than over the short term. In the case of an equity, such a situation might arise if the company in question goes out of business, or if its business is irreparably damaged, which creates losses for the investor that are permanent. So, important risk relates to permanent loss of capital, not day-to-day losses, the vast majority of which are temporary.
Instead of thinking of volatility as a risk (and therefore something to be concerned about), think of it as the cost of the longer-term return. And if you’re able to ignore the fluctuations from month to month in the value of your investments, it’s a cost you won’t notice.
Diversification is a fundamental principle for multi-asset investing
Avoiding permanent loss of capital requires careful analysis of the investment in question. In the case of an equity, it requires analysis of the company’s business prospects and how the business is financed. But you can also reduce the impact of a company going out of business (for example) by diversifying your portfolio across a number of investments. Indeed, diversification is a fundamental principle, not only of multi-asset investing, but investing in general. The question is not whether you should diversify, but how much you should diversify.
The financial theorists suggest that you should diversify as much as possible. By doing so, they say, the impact of any one company going out of business is minimised. But such minimisation of loss means you’re also minimising potential gain. This is why others, including renowned investor Warren Buffett, suggest that diversification beyond a certain point is counterproductive. In Buffett’s own words, “Wide diversification is for people who don’t know what they’re doing.”
At one end of the risk spectrum we have bank deposits, and towards the other end, equities. In between the two lie asset classes such as government and corporate bonds. Governments rarely go out of business, but their bonds are considered somewhat risky given the propensity of central banks to create inflation – the bane of bonds – when debt becomes too large. Corporate bonds are less risky than equities, because in the event of bankruptcy, remaining assets get paid to bondholders first. Further along the spectrum beyond equities we encounter financial derivatives, such as options and warrants, where the possibility of permanent loss of capital is higher.
How can asset classes be combined?
Having considered the attributes of single asset classes such as bank deposits and equities, we can now look at how they and others can be combined in a portfolio. A fairly simple multi-asset portfolio would comprise equities, government bonds, corporate bonds and cash. Precisely how these asset classes should be combined will be covered later, but the expected return from the portfolio would be determined by the expected returns of each of the underlying asset classes and their weight in the portfolio (known as the weighted average).
Determining the expected returns from cash or bonds is fairly straightforward; you simply need to know the deposit rate (in the case of cash) or the yield (in the case of bonds), with the latter adjusted for what is generally a fairly predictable probability of default. As for equities, there are a number of ways of assessing the expected return. You can look at what equities have returned in the past and assume they will do the same in the future (although this approach is not recommended). Alternatively, you can use a ‘dividend growth model’, which says that the expected return from an equity is equal to its current dividend yield plus the long-term dividend growth rate. Then there are other more complex models which derive expected returns of equities over and above cash or government bonds, from their price volatility. Regardless of which method you employ with respect to equities, the point to remember is that it is possible to assign expected returns to each asset class and consequently to derive the expected return of the overall portfolio.
Aim for smoother, less volatile returns
Different asset classes have their own expected return. These can be combined in different ways to target a particular return. For example, assume that bank deposit rates are 0%, the expected return from bonds is 5%, and that from equities is 10%. To aim for a return of 5%, you can either invest the entire portfolio in bonds, or split the portfolio 50/50 between equities and bank deposits (or one of many other possible combinations). Which should you choose? As well as expected or required return, an equally important consideration of a portfolio should be the smoothness of the path that leads to achieving those returns.
While both of the aforementioned options would be expected to produce a long-term return of 5%, one of them may travel a smoother (less volatile) path.
Calculating the volatility of your portfolio
Unlike the expected return of the overall portfolio, to calculate the volatility of the overall portfolio, you don’t calculate the weighted average of the volatility of each asset class. To understand this, consider two investments: one that goes up one week and down the next, and another investment that goes down one week and up the next.
Individually, they are both volatile, but if you combine them in a portfolio, their movements cancel each other out such that the volatility of the overall portfolio is much lower than the weighted average of each asset class’s volatility. The maths is somewhat complicated, but to calculate the overall volatility of a portfolio, you need to know how the underlying assets behave in relation to each other as well as individually. For example, in recent years fixed income investments have generally been inversely correlated with equities (ie when equities rise, the value of bonds will fall, and vice versa) due to different market and economic conditions favouring each asset class. This means the losses from one could potentially be offset by gains from the other.
So having set your objectives, decided on your required return, and determined the least volatile combination of asset classes, you now have a multi-asset portfolio. The precise combination is known as the portfolio’s asset allocation and can be changed either to reduce risk or enhance return.
Published in Aberdeen marketing
The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.