Written by Adrian Meager, Head of Asset Management, Warwick Wealth
“Games are won by players who focus on the playing field – not by those whose eyes are glued to the scoreboard.” ― Warren Buffett
What is Asset Allocation?
Asset allocation is an investment strategy that aims to balance risk and reward by apportioning a portfolio’s assets to an individual’s goals, risk tolerance and investment horizon. The three main asset classes are equities, fixed income (bonds) and cash. Each of the asset classes has different levels of risk and return which means each will behave differently over time.
How to manage Asset Allocation?
There are different methods to manage the asset allocation for multi-asset class portfolios with some Asset Managers preferring a “top down” strategy and others a “bottom up” approach. At Warwick, we prefer a combination of a “top down” and “bottom up” approach.
“Top Down” investing is an investment approach that involves looking at the overall economic environment and then breaking down the various components into finer detail. Warwick Asset Management’s capital market expectations are the basis of our top down approach. We examine four critical components that drive our overall macro view: Our expectations on inflation, interest rates, a forecast on economic growth and the South African Rand.
Once we have completed our capital market assumptions we then incorporate these into an expected returns calculation. These calculations calculate our expected returns for equities, bonds, listed property, preference shares, commodities and cash, which enables us to make a calculated decision on which asset classes to invest in to try maximise our clients’ returns. Once these steps have been completed, we begin our rigorous stock selection process.
“Bottom up” investing focusses on the attractiveness of assets through analysis of individual stocks and then building a portfolio based on the attractiveness of those assets. The asset allocation is the result of what the individual asset manager finds attractive. As the bottom up process is driven by the attractiveness of individual stocks it is possible that Warwick Asset Management may purchase when the stock market is deemed expensive on the whole as we still see value in the particular equity relative to other securities. We may also find a number of undervalued stocks in a particular sector and thus, have an overweight position to that sector. This is where Warwick is best able to utilise the combination of a top down and bottom up approach.
Perhaps no single investment principle has more impact on portfolio performance than asset allocation and while asset allocation does not ensure capital growth or provide a guarantee against loss, academic research has shown that asset allocation is responsible for more than 90% of a portfolios positive performance over time.1
As asset allocation has such an impact on performance that we continually review our strategic asset allocation and amend our model portfolios in line with our house view. We remain true to our investment philosophy “Long only, active and consistent” and will continue to manage our client’s investments in line with this.
1. See Gary P. Brinson, L. Rudolph Hood, and Gilbert L. Beebower, 1986, “Determinants of Portfolio Performance,” Financial Analysts Journal vol. 42 (4), July/August pages 39-44 (reprint, 1995, Financial Analysts Journal 51 (1), pages 133-138, 50th Anniversary Issue). Gary P. Brinson, Brian D. Singer, and Gilbert L. Beebower, 1991, “Determinants of Portfolio Performance II: An Update,” Financial Analysts Journal 47 (3), pages 40-48; Roger G. Ibbotson and Paul D. Kaplan, 2000, “Does Asset Allocation Policy Explain 40, 90, or 100 Percent of Performance?”, Financial Analysts Journal 56 (1), pages 26-33.