Strategic Asset Allocation
02nd March, 2022
Portfolio Creation Process
There are four drivers of performance in your portfolio. In this series, we will look at each in detail, providing insights into how we build portfolios.
Strategic asset allocation is the first article in this series. To read the other articles, click here.
The portfolio creation process
What is a Strategic Asset Allocation?
The Strategic Asset Allocation (SAA) is your long-term target allocation. As such, it provides the anchor for your portfolio from which all subsequent investment decisions are made. It is based upon three key factors:
- return objectives,
- risk tolerance, and
- investment time horizon.
The SAA differs from the other drivers of portfolio returns as it is set in advance, whereas factor exposures, tactical decisions and fund selection are decisions made by the investment team over the course of your investment time horizon.
Return objectives: Your SAA will be the biggest determinant of returns in your portfolio, making it your most important investment decision.
Risk tolerance and your capacity to take risk: While having too much risk in your portfolio may seem like the most obvious mistake, taking on too little risk can impact your ability to achieve your financial goals – particularly after the effects of inflation. A portfolio with the right balance of growth and defensive assets, with an appropriate level of diversification across (and within) each asset class can help you remain fully invested over the longer term.
Investment time horizon: While future returns are uncertain, and your risk tolerance is subjective, your investment time horizon is more easily predictable and can influence or even override the other factors. We know that the longer you can stay invested for, the greater your ability is to take risk. Conversely, over very short time horizons you may be able to take little to no risk at all.
How we set our Strategic Asset Allocations
The SAA is designed to achieve long-term goals and it is the most significant determinant of returns for investors. When we construct portfolios, we try to maximise your potential return, for a given level of risk. We do this by blending traditional (equities and bonds) and non-traditional (alternative assets like property absolute return and infrastructure) asset classes in portfolios; sizing positions in a way that aims to achieve the optimal return for each risk mandate.
Portfolio risk is the key consideration when setting strategic asset allocations. When making asset allocation decisions, we assess the probability of negative events occurring and the impact they could have on your capital value, particularly as you approach a stage where you might need to draw on your portfolio.
Historically, matching return requirements with a client’s risk tolerance had been a straightforward process, as strong returns from both fixed income and equities ensured they were able to achieve the desired returns without taking on too much risk.
Today’s investing landscape is very different to that of prior decades, with equity markets at all-time highs and bond yields at all-time lows. Low bond yields typically indicate lower future returns for bonds, while higher than average equity market valuations have historically led to below average returns. The below chart gives an indication of how much yields and valuations have changed in recent years, suggesting achieving similar returns in the future without changing the level of risk in your portfolio will be challenging, particularly for lower risk investors:
Changes in bond yields and equity market valuations 2010-2020
Source: Bloomberg, values as at 01-Jan of each year.
UK 10-year bond yield and Shiller PE ratio described in more detail in glossary of terms below.
This means that investors might face a difficult decision between either resetting expectations or taking on more risk (with an acceptance of the associated increase volatility).
Ultimately, the overriding objective is that our clients achieve the best risk-adjusted outcome suitable to their individual circumstances. This may mean accepting greater short-term volatility to achieve these goals, but for many we believe the long-term risk of failing to keep pace with inflation may be the greater evil. By developing a plan and reviewing it regularly you stand a better chance of achieving your goals.
If you would like to hear more about how our team of investment experts can help you build an investment strategy to meet your goals, please contact our office on +44 (0) 2890 310 655 and request a call with one of our Davy UK Wealth Managers.
To read more about the four sections of the portfolio creation quadrant, click on the articles below.
Strategic Asset Allocation
Your most important decision, how we help you arrive at an appropriate allocation and the implications for your long-term objectives.
Style Factor Bias
The group of characteristics that we look for in the stocks that underlie your portfolio.
The final part of portfolio construction, the individual instruments that convey our views.
Tactical Asset Allocation
How we invest your money with shorter term risks and opportunities in mind.
Glossary of Terms
Shiller PE ratio: a PE (or price-to-earnings) ratio is used to value equity markets by comparing share prices to the aggregate earnings of companies in the market index. Simply put, a PE ratio of 15 means that the market value is equal to 15 times its annual profits. The Shiller PE ratio was devised by the Nobel prize winning economist Robert Shiller and differs from the traditional PE ratio in that it uses a 10-year average of earnings to smooth out profit fluctuations over a business cycle, while also adjusting for changes in inflation over the period.
UK 10-year bond yield: the interest paid on bonds issued by the Bank of England which mature 10 years after issuance.
WARNING: The information in this article does not purport to be financial advice as it does not take into account the investment objectives, knowledge and experience or financial situation of any particular person. You should seek advice in the context of your own personal circumstances prior to making any financial or investment decision from your own adviser.
WARNING: Past performance is not a reliable guide to future returns and future returns are not guaranteed. The value of investments and of any income derived from them may go down as well as up. You may not get back all of your original investment. Returns on investments may increase or decrease as a result of currency fluctuations.