The benefits of having a diversified portfolio across asset classes are well understood. Strategic asset allocation offers several key benefits for an investment portfolio. Firstly, it provides a disciplined and long-term approach to investing. By setting a fixed allocation based on an investor's risk tolerance, financial goals, and time horizon, strategic asset allocation helps prevent knee-jerk reactions to short-term market fluctuations. This reduces the likelihood of emotional decision-making, which can often lead to poorer results. Instead, it encourages investors to stay the course and maintain a well-diversified portfolio that can weather various market conditions over the long run.
Secondly, strategic asset allocation seeks to achieve a balance between risk and return. By spreading investments across different asset classes, such as stocks, bonds, and cash, it diversifies the portfolio's risk. During periods of market volatility or economic downturns, certain assets may underperform, but others may act as a buffer, mitigating potential losses. Over time, this balanced approach has the potential to deliver consistent, more stable returns compared to more aggressive or concentrated strategies. Additionally, strategic asset allocation allows for periodic rebalancing, which entails selling assets that have outperformed and buying those that have underperformed, effectively "buying low and selling high." This disciplined rebalancing process helps maintain the desired allocation and can enhance returns over the long term. It’s the general principles of diversification and strategic asset allocation.
But sometimes it’s important to be more dynamic in your decision-making process. The diversified nature of the portfolio assets allocation was meant to help weather any storm. While equities can be more volatile in tough times the bond portion of the portfolio provides the less volatile and more defensive fixed income assets. But in 2022 both equities and bonds experienced significant declines. At one point the Bloomberg Aggregate Bond Index down -20%, which is almost unheard of for safe, secure, boring old bonds. The reasons were very straight forward. It was due to the rapid rise of interest rates, as fast an increase as there has been at any point in the last 40 years. This is why it is important to avoid being too complacent or passive in your investment approach.
When once in generation events occur, sometimes your decision making needs to adjust. In 2022, with interest rates rapidly rising from almost 0% to 4%-5%, it was apparent that this would impact both stocks and bonds negatively. It is important to be able to think tactically here and make dynamic decisions with regards to your investment portfolio. We took the view that in this situation we wanted to be underweight both equities and fixed interest. It meant increasing our exposure to cash, term deposits and floating rate bonds. By doing this, we avoided losses on the bond component of the portfolio while minimising losses on the stock component that year. At the time, many portfolio managers stuck with their strategic asset allocation and lost a lot of money. Thinking and acting tactically was critical in generating a far better outcome for our clients.
Now in 2023, as interest rates approach their peak that situation is rapidly changing again. It means that where we avoided fixed rate bonds previously these are now becoming much more attractive. Interest rates on fixed rate bonds are much higher, offering a very reasonable yield, and the prospect of rates going much higher from here is lower. So, the risk of capital loss is minimized. If inflation continues to cool and rates do come down, there is the prospect of these bonds increasing in value. With the recent improvement in equities, it provides the opportunity to take advantage of higher share prices, lock in some profit and reallocate that capital to the more defensive part of the portfolio at attractive prices.
While strategic asset allocation provides an essential foundation for a well-diversified and disciplined investment approach, there are times when a more dynamic and tactical decision-making process is necessary. The events of 2022, with the unprecedented rise in interest rates impacting both equities and bonds, serve as a stark reminder that complacency in investment strategy can have adverse consequences. Recognising unique situations and being willing to adjust allocations accordingly can be the key to navigating through challenging market conditions successfully. As we move forward through 2023, with interest rates approaching their peak and changing market dynamics, the importance of flexibility and adaptability in portfolio management becomes even more important.
General Advice Disclaimer: This information is of a general nature only and may not be relevant to your particular circumstances. The circumstances of each investor are different, and you should seek advice from an investment adviser who can consider if the strategies and products are right for you. Historical performance is often not a reliable indicator of future performance. You should not rely solely on historical performance to make investment decisions.