When it comes to your investment outcomes, what is the one most important thing you need to get right? What is the one thing that if you get it right will give you the best chance of meeting your investment goals over the chosen time periods?  What is the thing that I as an adviser focus on getting right when it comes to offering investments which are going to need to meet your goals?

Your asset allocation.

What is an “asset allocation”?

Your asset allocation is is the split of your portfolio between the various asset classes. For example, your asset allocation may be 50% local equities, 25% foreign equities, 10% bonds, 10% real estate and 10% cash.

Why is it so important?

There have been many research papers published looking at the factors that affect investor returns over time. As an adviser I want to know that the investments I recommend to my clients will have the highest possible probability of meeting my client’s needs. To get this right I need to know the factors that affect these outcomes and how important each of them are. If I can work with my client to identify and manage these factors in their favour then I can feel confident that the probabilities of reaching the right outcomes can be increased, which will lead to greater peace of mind for everyone.

What factors are the greatest predictors of investment outcomes?

The seminal work in this regard is often quoted to be the study done by Brinson, Hood & Beebower  (Determinants of Portfolio Performance,  Financial Analysts Journal, 1995).  They said that their task was “to rank in order of importance the decisions made
by investment clients and managers, and then to measure the overall importance of these decisions to actual plan performance.”

They wanted to know the relative importance of investment policy versus investment strategy. They said that investment policy identifies the long-term asset allocation plan (included asset classes and normal weights) selected to control the overall risk and meet fund objectives. On the other hand, investment strategy is shown to be composed of timing, security (or manager) selection, and the effects of a cross-product term.

Using data from 91 portfolios over a 10-year-period (a good data set), they concluded that investment policy return explained on average fully 93.6% of the total variation in actual plan return, with the balance (market timing, security or manager selection etc…) determined by employing a particular investment strategy.

Implications

The authors concluded that the design of a portfolio involves at least four steps:

FIRST: deciding which asset classes to include and which to exclude from the portfolio;

SECOND: Deciding upon the normal, or long-term, weights for each of the asset
classes allowed in the portfolio;

THIRD: Strategically altering the investment mix weights away from normal in an
attempt to capture excess returns from short-term fluctuations in asset class
prices (market timing); and

FOURTH: selecting individual securities within an asset class to achieve superior returns
relative to that asset class (security selection).

The first two decisions are properly part of investment policy; the last two reside in the sphere of investment strategy. Because of its relative importance, investment policy should be addressed carefully and systematically by investors.

Conclusion

When working with clients we know what factors are important in achieving the right result and we focus on getting them right. Investors are individuals and what is right for each investor will vary and change over time. Getting these plans right and keep the plans on track is what a good Independent Certified Financial Planner® will focus on.

It’s important.

Disclaimer: The information provided is not intended to address the circumstances of any particular individual or entity and should not be considered to be advice in any way. No person should act upon this information without first obtaining professional advice.

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