Asset allocation and long term investment; a simple rule of thumb

by George Hatjoullis

An article by Merryn Somerset Webb in the FT ( extolls the virtue of holding cash in an equity portfolio. Hardly a dramatic suggestion. In reality the article is an attack on fund managers for always being fully invested and not holding cash. For those of us that manage our own asset allocation fund managers should be fully invested. Otherwise one never really knows what asset allocation one has. For those that do not want to manage asset allocation there are balanced and total return funds so I have no idea what point MSM is trying to make other than always hold some cash. Good advice but even Yosser Hughes could do that.

English: Markowitz-Portfolio Theory, Investmen...

English: Markowitz-Portfolio Theory, Investment Portfolio Management (Photo credit: Wikipedia)

However, it does prompt me to consider the question of long-term personal investment strategy and asset allocation for the DIY investor. My own simplistic rule-of-thumb has been to hold one-third equity, one-third bond, one-third cash. I do overlay a lot of other strategies on top of this but some version of this simple rule could benefit all uninformed investors (i.e. most people).Moreover, I rebalance at least once a year. It is an easy strategy to apply when one is still saving as one simply allocates the new saving accordingly. After retirement it may be necessary to actually buy and sell assets.

It is basically equivalent to averaging in and averaging out. If equities do especially well one sells an appropriate amount and invests in cash or bonds. During bear markets one is buying into a falling market at least once a year. It does mean one often sits on equities in a bear market and watches them fall rather than selling! This can be difficult. However, one can always console oneself by looking at overall portfolio return and recalling that 2/3 of the portfolio is doing rather well. The real risk is in a bull market when one might get carried away and allow the portfolio to become unbalanced.

Curiously enough this asset allocation is consistent with the individual investor behaviour assumed in modern portfolio theory. I am holding a combination of some proxy for the market portfolio and the risk free asset. I am holding a well diversified portfolio of equities and setting my overall portfolio risk through my holding of risk free assets (quite how risk free cash and bonds are these days is another matter). I guess all those years studying and teaching finance had some effect.

For the uninformed (and uninterested) in markets some version of this arrangement makes sense as a long-term strategy. It means you do not need expensive advice. It means you can choose low-cost tracker funds. It means you can set the risk exactly where you feel comfortable. IFAs always ask for your risk preference. In my experience, capacity for risk is never obvious until one is invested and the game begins. Most people have low risk tolerance.

Note that this strategy makes sense at whatever age you might be. Advisers will normally suggest such a low risk structure as you approach retirement but may be more cavalier if you are 25. The logic is you can then ‘afford’ to take a long view and have 100% equities. This rather misses the point. Equity markets do trend up but they can have reversals and flat periods that can last a long time. Moreover, seeing your fund fall for, say, three years can be a big disincentive to continue saving. The balanced strategy smooths the process for the nervous, uninformed saver and has the portfolio increase investment in equities in down years when most non-professionals are reluctant to invest.