Asset Allocation

Theory versus Practice

In theory five basic principles should dominate both strategic and tactical asset allocation decisions in lifestyle fund management. In practice the defined contribution pension plan (a.k.a. money purchase pension scheme) of most vendors doesn't enable the investor to live by those principles, nor do many other investment vehicles, so you have to decide for yourself, using our Lifestyle Asset Allocator for your own pension plan.

1. In theory, the key consideration in a lifestyle fund, the balance of investment objectives within any investment plan should shift from growth to income over the working lifetime of a plan holder. In practice, most vendors offer only a single one-size-fits-all managed fund to investors of all ages in their defined contribution plans.
2. In theory, considerations of capital preservation in a portfolio should reflect the financial circumstances of each investor. In practice, sales and compliance pressures push many Independent Financial Advisers to recommend the default option which is the managed fund. This applies the same risk profile to all holders irrespective of age. Similar factors also operate in other countries.
3. In theory, the principal issue in tactical asset allocation within any lifestyle fund, the choice of shares, bonds or cash should be adjusted in the light of market circumstances. In practice, few fund managers do much more than tinker at the margins.
4. In theory, the second concern of tactical asset allocation, the geographical composition of holdings within each asset class in any pension plan should reflect changes in the comparative attractiveness of different regions of the world at different times. In practice, few fund managers of managed funds will go as far as to reduce holdings to zero in any region that they find unattractive.
5. In theory, a growing third tactical asset allocation consideration among fund managers is the emphasis on different investment styles as the market climate changes. In practice, performance measurement services rate consistency highly, so many managers stick with a particular style irrespective of market conditions, so investors in defined contribution pension plans are often denied choice of styles even when they do have a geographical choice.
6. In theory, diversification is a good thing. In practice one can have too much of a good thing, as the benefits of increasing diversification decline with every additional equity asset held in a portfolio.

Lifestyle Asset Allocator

In theory, at the start of one's career one should invest in equities for growth but at retirement invest in fixed interest securities for income. This implies that one should steadily switch from equities into fixed income investments over an earning career.

In practice, this table shows how you can adjust the proportions of stocks and shares yourself. When starting a career around the age of 20, growth is the sole objective, so equities can represent all of fund. However on retirement, and by law in the United Kingdom at the age of 75, your pension fund must be converted into an annuity, to provide an guaranteed income for the rest of your life, which is done by capital repayment and interest earned on long dated government bonds. Hence the balance of a typical fund might start by containing 100% equities and end with 100% fixed interest investments. You should adjust that in the light of market circumstances.

Risk Profile

In theory, individual circumstances differ, so it may be acceptable for investors in some money purchase pension schemes to strike the balance at a higher level of higher risk and return, shown as the green line, while others may be better advised to go for a more conservative approach, shown as the red line, while the typical position is shown as the yellow line. 

In practice, the right balance for any particular defined contributions pension plan will therefore depend not only on age, but also on income, outgoings and other assets. Here is a crude way of providing some guidance using a self-assessment questionnaire on these key considerations. If you score 24 or more, the higher risk profile may be acceptable, but if your score is 12 or less, it would probably be prudent to adopt the lower risk profile.

Shares, Bonds or Cash

In theory, the balance you strike within your individual pension plan should also fluctuate around this norm depending on market conditions. Investors RouteMap , our tactical asset allocation software, applies a range of multi-disciplinary active quantitative strategies to generate Buy/Sell ratings on each asset class both globally and within the home market for investors in all the major developed countries and many emerging markets.

In practice, we believe that it is asset allocation, rather than the choice of manager that counts as this is predictable - not entirely, but at least with a useful degree of accuracy. Our asset allocation software has been back-tested, where possible, over a quarter of a century for all the countries and regions included in the RouteMaps. Our research shows that there are some strategies that work in a wide variety of conditions and over long time periods in most places.

Geographical Allocation

In theory, pension plan portfolios should be constantly adjusted in anticipation of changes in growth, inflation, yields and exchange rates between regions. In practice few fund managers do much more than tinker around at the margins.

In practice, subscribers to the Investors RouteMaps can use our asset allocation software to analyse markets not only in absolute terms but also relative to each other using the Global View charts which show relative performance charts that include our computer-generated Best Guess as to the future direction of each market. Every month these recommendations are reviewed and published in summary tables. 

Investment Style

In theory, certain investment styles work consistently for certain fund managers, at least according to the performance charts often used to advertise funds. In practice, past performance is a poor guide for choosing fund managers, because styles go in and out of fashion. The latest addition of our range of asset allocation software, the Styles RouteMap shows what worked in the past and what we expect to work in the future, based on our technical and fundamental research of the six most popular kinds of investment style and sector funds.

Dynamic Diversification

In theory, portfolio theorists believe that diversification reduces risk. However there is more to risk than volatility. Furthermore there is little gain from diversification into assets with high levels of price correlation. In practice, all that wide diversification ensures is a commitment to mediocrity as such a portfolio cannot avoid containing under-performing assets. In technical terms, there is a trade off between alpha (performance) and beta (volatility). Instead a strategy of dynamic diversification may be preferable - switching between a small selection of poorly-correlated equity assets with better prospects, as recommended to subscribers of the RouteMaps.