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On the starting grid

In my last few articles, I have examined features of the major asset classes and predicted how they might perform in the future. I have paid particular attention to the volatility of the individual asset classes and their combined behaviour, noting the extent of their correlated performance.

In my last article, I said that I would conclude this series by bringing together all the issues in a selection of model portfolios with projected growth rates and volatility ratios. I will use as a framework a model portfolio grid which is used in my firm (above right).

Before ascribing suggested asset allocations to each of these portfolios, suffice to say that portfolio A is clearly designed to produce the lowest overall level of risk, driven by the short investment term and low investor attitude to risk, while portfolio I has the highest expected level of risk due to the longer investment term and higher investor attitude to risk.

I need to stress that this asset allocation framework is based on a combination of the highest expected returns for a given maximum level of risk or, looked at another way, the lowest level of expected risk for a given desired level of returns. However, it could be varied according to the assumptions used by the adviser and his or her assessment of the client’s requirements.

Let us start at portfolio A, which should represent a low level of expected risk, even over the short term. There arguably should be little disagreement that an appropriate asset allocation should be 100 per cent cash. The projected rate of return, especially over the short term, should be no more than 4.5 per cent gross, as I summarised last week in a table showing projected rates of return for different asset classes (centre).

Note that I am using the term “gross” to denote the return before any tax liability within the fund or on the investor and before taking into account charges within the investment vehicle.

Progressing through these portfolios, you will note that portfolio B may be recommended either to investors with a higher acceptance of risk or who are prepared to commit their investment over a longer timeframe although not both.

This is where some personal opinion and assessment by different advisers will impact on the asset allocation. For the purposes of this article, I will still avoid the higher-risk asset classes and suggest, say, 75 per cent cash and 25 per cent fixed interest. If the fixed-interest part of the portfolio is concentrated on a fund spread between gilts and a range of corporate bonds – avoiding the lowest-grade or junk bonds – we might assume the gross rate of return from this fund to be somewhere around 5 per cent, giving an expected overall rate of return from portfolio B as shown below.

Any investor or adviser could be forgiven for wondering why it would be worth accepting a higher – albeit only slightly higher – level of risk for such a slight increase in expected returns. Such musing is surely to be welcomed as it helps to focus minds on whether to accept this balance or opt for total security or, conversely, a slightly higher level of speculative portfolio. Read on.

Portfolio C is suggested as being appropriate to those investing over an even longer term than clients in the portfolio B category or those with an even higher acceptance of risk or those with a combination of both.

Note here the diagonal nature of the suggested portfolios in the grid, representing the widely accepted principle that the degree of risk in any investment tends to diminish over longer periods of time. Thus, a similar portfolio might be just as appropriate to a higher-risk client investing over the shorter term as a lower-risk client investing over the longer term.

An appropriate asset allocation for portfolio C might be as shown below.

Despite all my observations about the healthy returns from commercial property – which still comfortably exceed 18 per cent a year – one cannot expect or even hope for this exceptional performance to be maintained over the longer term. I am thus using a much more conservative estimate of 8 per cent despite the fact that rental yields alone are not much lower than this figure.

Whatever estimated returns one chooses to use for commercial property, it should be generally agreed that likely returns for the foreseeable future can be expected to exceed those from deposit-based and fixed-interest investments.

Supporters of the use of good quality commercial property funds in the structured portfolios of investors in many different circumstances would point to the lower correlation of this asset class with alternative investments, reducing portfolio risk while increasing overall expected portfolio returns. Some evidence of the validity of this point of view is provided by the increased expected return from portfolio C.

In my next and final article in this investment-based series, I will look at uses of the model portfolios I have already discussed and the remaining portfolios which, as could be anticipated, make increasing use of equity-based investments to increase expected returns, at the expense of increased portfolio risk.

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