No one can control markets or guarantee investment returns. In a way, we are passengers on our investment journey. However, we do have full control when it comes to choosing where our funds are allocated – deciding on specific asset classes and investments. This strategic asset allocation is a critical decision, and I’d like to outline our evidence-based approach to it.
In the short run, investment returns are unpredictable
The table below sets out investment returns for various asset classes by calendar year. Returns are sorted from high to low and colour-coded.
This 3-decade period highlights that there are no discernible patterns. For example, bond returns are not always inversely related to share market returns. And residential property doesn’t seem to have any correlation with other asset classes.
Given this evidence demonstrates we cannot predict which asset classes will produce the highest returns in the short term, it makes sense to spread your investments across many asset classes.
However, in the long run, returns are more predictable
Whilst it’s almost impossible to predict what asset classes will do in the short term, longer-term outcomes are a lot more predictable, mostly thanks to the immutable law of mean reversion.
Investing in an asset class that’s shown below-average returns over the past 5 to 10 years often indicates that future returns could exceed the long-term average. While this suggests higher returns ahead, the timing of when the asset class will revert to its mean is less predictable. It’s conceivable that the asset class might continue underperforming for a few years after you’ve invested.
Therefore, you must expect underperformance
Take the US stock market as an example: between 2001 and 2010, it underperformed, posting an average annual decline of -4.6%. Given the historical average annual return of around 10% p.a., this period was roughly 15% p.a. below par. It shouldn’t come as any surprise that between 2011 and 2023, the market surged, boasting an average annual growth of 15.9% p.a., significantly outperforming the long-term average.
If you’d invested in the US market in early 2006, following a 5-year slump, your returns for the subsequent 5 years (between 2006 and 2010) would have been disappointing, resulting in nearly a 20% loss on your initial investment. However, by 2023, your 18-year investment would have yielded an average annual return of close to 10% p.a. which is bang on the long-term average return.
This illustrates that using mean reversion as a basis for asset allocation decisions will not always maximise short-term returns, it almost certainly will in the long term, which is the most important objective.
Chasing returns is risky
The weakness of some investment funds, including superannuation funds, is that they force all investors to adopt the same asset allocation. We believe that this doesn’t allow investors to maximise investment returns.
When we invest new capital, like superannuation contributions, we consider which asset classes or geographical markets exhibit the greatest potential to deliver above-average future returns. By directing new capital towards these markets, we reduce portfolio risk and position it for long-term outperformance.
This strategy may lead to imbalances in our client portfolios. For instance, three to four years ago, we allocated a larger portion of new capital into the UK market due to its perceived value. Consequently, many of our client portfolios were very overweight in the UK market, which we were comfortable with. Over the three years ending in March 2024, the UK market has been the best-performing market, even surpassing the US market by a slight margin, so this approach has already paid dividends, and we expect it to continue to do so over the long run.
A consequence of this approach is that each client portfolio will have a unique asset allocation because our clients invest capital at different times.
We are comfortable with an ‘unbalanced’ asset allocation
The way you invest new capital is a critical decision.
Following a template asset allocation means that you have no regard for how attractive each market is in terms of future expected returns. Investing in markets that have outperformed in the past 5 to 10 years, like the US market, carries risks. Evidence suggests that overpriced markets tend to underperform in the subsequent decade.
Strategic allocation of new capital can help minimise risk and maximise returns. However, it requires the discipline and conviction to adopt and maintain an unbalanced portfolio. Blindly following what conventional wisdom suggests is a theatrically correct asset allocation is dumb in our view because it ignores opportunities to maximise future returns.
Few take this approach for the wrong reasons
Regrettably, many financial advisors, superannuation trustees, and investment products adopt a one-size-fits-all asset allocation approach for two main reasons. Firstly, it’s more time-efficient to apply uniform asset allocation across all client accounts. Secondly, it is perceived to reduce their business risk because they are following the crowd.
We acknowledge that it is more time-consuming to construct bespoke portfolios for each client. However, our job is to put our clients’ best interests first before other priorities such as streamlining business operations or reducing perceived business risk.
When investing new capital, we believe in following a 3-step approach.
Firstly, identify asset classes or geographical markets that exhibit the best opportunities for providing above-average future returns.
Secondly, always employ evidence-based strategies, such as rule-based, low-cost indexing to invest in these markets.
Lastly, maintain a long-term perspective. Resist the urge to sell investments. If rebalancing or reducing exposure becomes necessary, use new capital to dilute existing exposures, where appropriate.
