Asset Allocation
"The idea that any single individual without extra information or extra market power can beat the market is extraordinarily unlikely. Yet the market is full of people who think they can do it and full of other people who believe them….Why do people believe they can do the impossible? And why do other people believe them?
Daniel H Kahnemann, 2002 Nobel Laureate in Economics.
Our approach to asset allocation is based on the Nobel Prize winning work of financial economists and has been developed from decades of empirical research. This approach, commonly referred to as "asset class investing", is common within the institutional market but is rarely offered to private clients.
So, what are the differences, and why is it that asset class investing is superior and why is it not often offered to private clients?
The key difference is that the traditional stockbroker will attempt to add value by the selection and trading of stocks, while asset class investing relies upon the allocation of the portfolio to various asset classes to deliver returns.
The rationale for asset class investing is simple: capital markets work and diversification between asset classes increases return and reduces risk. Over the long run, markets reward investors with positive returns for taking risks and providing capital. If they did not, the capitalist system would have collapsed long ago.
Market prices reflect the knowledge and expectations of all investors. Nearly forty years of academic research has shown that traditional managers are unable to outperform the markets by anything more that we would expect by chance.
So, if history shows that selecting individual shares cannot consistently provide reliable investment returns is there a better strategy?
A collection of the best evidence from the academic disciplines of economics and finance suggests that there is. Investment experts usually summarize this evidence as a body of knowledge called "modern portfolio theory". The foundation of Modern Portfolio Theory was a 1952 paper, "Portfolio Selection" by Dr Harry Markowitz in which he established a theory explaining the best way for an investor to choose a portfolio. Modern Portfolio Theory is of such fundamental importance in investing that the economists that formulated the theory received the Nobel Prize in Economic Science in 1990.
Modern Portfolio Theory has four basic premises:
* Investors are inherently risk averse. Investors are more concerned with risk than they are with reward. This sets them apart from speculators.
* Securities markets are efficient. Most studies support this idea.
* The focus of attention should be shifted away from individual securities analysis to consideration of a portfolio as a whole, predicated on the explicit risk/reward parameters and on the total portfolio objectives. The efficient allocation of capital in a portfolio to specific asset classes is far more important than selecting the individual investments.
* For every risk level, there is an optimal combination of asset classes that will maximise returns.
Portfolio diversification is not so much a function of how many individual stocks or bonds are involved, as it is of the relationship of each asset to each other asset. Asset allocation therefore involves dividing an investment portfolio among different asset categories such as equities, fixed interest, cash and property and the process of establishing which mix of assets to use, is largely determined by investment objectives, time horizon and tolerance to risk.
Our approach to asset allocation is different to that usually employed in the Irish market and, we believe, delivers considerable value benefits to our clients.