Asset Allocation And Portfolio Management For Individuals

I thought I might explain some basics of asset allocation and portfolio management. There are reasons for this.

In my day to day work, I keep speaking to clients to whom investment is only considered in terms of return. Many (and I mean this in the nicest possible way), have never heard of asset allocation. In some ways, they are quite right to think so. After all, the point is to make money, right?

Well, yes and no. As I am sure you are aware, there are different types of asset which have risk levels at the very low end or ultra high ends of the scale. It is this that makes asset allocation so important. As you know, government bonds from Canada and shares traded in Hong Kong are not alike. In such decisions, risk and return need to be somehow balanced. There are, of course, other decisions too, some of which will be discussed in a moment.

But in these regards, I find people think of investment management to be overly simplistic. It would almost be akin to saying that tennis is just about 'hitting a ball'. Quite clearly this is true, but there is so much more to it than that.

Therefore, I am going to start with a discussion relating to how fund objectives and constraints can influence the decisions taken by a fund manager or asset allocator. It will be up to you to relate that back to your own situation.

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Any, and probably, every fund has a document which lays down aims and objectives. Think of this as a terms of reference if you like. This may be a trust document, partnership agreement or contract between stakeholder and fund manager (this might relate to the contracting out of the fund management tasks by a company pension scheme, for example).

This document will usually lay down exactly what types of investment may be selected. A collective investment that specialises in Japanese small companies will have a set of defined terms which describe the types of investment to be found. This might relate to the class of share to be owned, the market the firm is quoted on, the size of the company, the number of years the firm has been trading or quoted for and much, much more.

On the other hand, a defined benefit pension scheme will be aiming to cover projected liabilities. Some of these liabilities will be short or medium term whilst others might be for the very long term (30 or more years away). Balancing this, as you might imagine, takes more than a little skill.

Therefore, two key types of objective exist. They are to maximise returns or to match projected liabilities.

The owners of the funds (stakeholders) will only be willing to accept certain amounts of risk in achieving these aims. The more risk averse a fund is, the lower the levels of risk that will be allowed and thus the potential for high returns will likely be diminished.

This will, of course, make it very difficult for the layman to compare like with like. Seeing that fund A has returned 18% in the course of a year, whilst fund B has produced just 9% seems like an easy comparison to make. One is simply better than the other. In my experience, this is how the public at large view investment results.

Fund complexity and communication issues lead to problems of comprehension by the public and fund investors. Bob Smith and Bill Smith, when chatting about their pensions over a beer are rarely going to consult the terms of reference of their funds to understand why they produced such different results.

I have no doubt that this is why there is often such suspicion of the fund management industry as a whole. Men in stripy suits with Gordon Gecko like red braces controlling the world, badly with greed being their only motive. They spend all day shouting 'Buy' and 'Sell', 'Greed is good' and 'Lunch is for wimps!'.

Sorry. I digress.

The objective of obtaining returns and risk tolerance is dependent upon a number of portfolio constraints. These are:

Liquidity Needs

Cash or assets that are near cash will be needed to cover everyday running costs, payments out of the fund and to respond to potential unexpected changes in circumstance. Investments held in a fixed income form usually give easier access to cash if required.

Time Horizon

The longer the time horizon of the fund, the more risk that it can tolerate. A pension fund with 'younger' members generally can allocate more assets to longer term and higher risk assets such as commercial property and equities. A fund with a high proportion of 'older' members (and therefore a shorter average duration of liabilities) must allocate using lower risk assets, such as fixed income investments with a duration that closely matches the liabilities.


A fund's tax status will influence the return objective and make some types of asset less desirable than others. Funds with a 'gross' status, charities for example, will avoid any tax free investments as these will usually trade at a premium in the market. This premium would provide no extra benefit to a tax free fund.

Legal and Regulatory

These issues must be borne in mind when constructing the fund.


The last decade has seen widespread approval of different forms of socially responsible investing. The various 'shades' of green will either include or exclude certain types of industry or company.

Issues such as these are vital for most investors. Yet amazingly, most investors are unaware of much of the real skill in the game. In investment, learning to assess risk and predict the future are almost everything. Sure, if we could predict the future we'd all be zillionaires. Well, Warren Buffett has learned to predict the future and assess risk and he is pretty wealthy. Should this tell us anything?

To subscribe to my monthly newsletter, I have a separate website established. The site has a webform connected to my mailing list. The webform contains a few questions about you the subscriber. Some are obvious: name, email address, country of residence but there are a few investment related questions too.

As an aside, I had a new subscriber a few weeks ago answer that her country of residence is the 'Land of the flying fish'. I have no idea who or where this person is, but it is officially my favourite answer. Wonderfully creative.

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I haven't done an exact survey of the responses, but I reckon that about 50% of new subscribers contradict themselves with their answers. I'm not saying that there is anything wrong with that, just that it highlights some unusual things. Or, perhaps it highlights that I'm no good at asking worthwhile questions!

Most people class themselves as 'a beginner' but about one third also class themselves as 'a trader'. Trading isn't for beginners. Most people that are traders, also view themselves as being 'cautious'. Trading isn't cautious either.

I guess that this relates to my comments above that the investment industry has some communication issues. I presume that if every time someone bought a book about trading the markets and the book said in big letters on the front cover that 'Trading May Harm Your Wealth', sales would be slow. I'm thinking now about the kind of bold health warning that adornes every packet of cigarette's.

Instead, we live in a world where (quite rightly) finance is regulated. This means that rather than have a warning that people understand, is catchy and memorable, financial services documents have warnings in small print that cover 19 lines of text and are full of legalese. These are impenetrable to many inside finance.

Perhaps this all relates to human nature more than other factors. We would all like to be wealthy. We would all like to make 'easy' profits in the market with little time spent and effort expended. Ideally, we would like to be sat on a beach in Hawaii at the time. Drinking a cocktail. Just like Fox Mulder, we want to believe.

However, if as individuals we plan to manage our own money, or understand how other people manage it for us, we need to get to grips with quite a few issues. We need to understand what we (or our fund) is trying to do. Is it the right fund for us? Does it's objectives match ours? Just 'doing well' is clearly not enough. Does it take risks that we would be unhappy with if we understood it more clearly?

Damn! You mean we have to do stuff? No beach? No cocktails? No 'easy' profits?

If you need the money back in a year or so, do look for a bond fund, do not use a hedge fund. Sounds simple and obvious, but you'd really be surprised.

I say these things because you have overall choice in asset allocation. Not a fund manager, not a financial adviser. It is your money. The list of factors above may be specifically related to how a fund manager operates, but in reality, you should be thinking about similar topics when you make your own investment decisions.

What are you trying to achieve? To maximise returns or to match your projected liabilities?

*This was first sent to my email newsletter subscribers in July 2006*

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