The market or economic cycle can be an investor’s best friend or worst enemy. How can asset allocation help financial planners, wealth managers and other investors take advantage of cycles?
According to a new report by AMP Capital, dynamic asset allocation (DAA), also known as active asset allocation, can help investors maximise the benefit of both market cycles and the power of compound interest. DAA involves increasing the allocation to assets when they are out of fashion and reducing when they are overvalued to maximise returns.
The benefit from compounding is shown by the historical performance of shares compared to bonds. While the average return from Australian shares since 1900 is 12% compared to the 5.9% achieved by bonds, over the whole period $1 invested in shares would have compounded to nearly $400,000 today, compared to just $727 if it had been invested in bonds.
However, cycles can result in declines, which can take a decade or longer to reverse such as in the 1930s, 1970s and recent decade for global shares. Rather than maintaining their investment strategy, investors often become spooked during downturns to reallocate to “safer” asset classes such as cash, thereby missing out on the long-term benefits of compounding.
To achieve maximum benefit from compound interest, investors should maintain an adequate exposure to growth assets, contribute regularly to their investment portfolio and avoid being thrown off course by investment cycles.
The three ways that cycles are typically managed comprise:
* Ignoring them and taking a “set and forget” approach to asset allocation. This may be suitable for long-term investors, but not for those nearing retirement or who have a shorter-term focus.
* Prepare for them using economic forecasts. A somewhat difficult strategy, given the mixed track record of economists’ forecasts (for example, the OECD recently admitted its economists completely missed the Global Financial Crisis and have regularly over-predicted the recovery’s strength).
* Using cycles’ rhyming elements to manage them. AMP Capital’s preferred approach, this involves capturing such elements to provide warnings of swings in the cycle. For example, downturns in equities are usually preceded by overvaluations, tight monetary conditions and excessive investor bullishness.
Numerous studies, including that of economists Eugene Fama and Robert Shiller who shared the 2013 Nobel Prize in Economics, have shown that markets are excessively volatile and tend to follow “mean reverting” cycles. This means returns need to be managed, making a rigorous dynamic asset allocation process essential.
Investment managers typically use active asset allocation to set ranges for strategic allocations to the main asset classes, based on expected returns and volatility over the long term, while adjusting allocations when an asset appears heavily over-bought or undervalued.
By doing so, investors can manage investment cycles and maximise short-term opportunities, while still maintaining long-term targets and asset allocations. And importantly, it is also possible to reap the rewards of compound interest, giving investments the potential to grow at a much faster rate over time.
While market and business cycles will always be a feature of economic life, effective asset allocation can make such volatility an investor’s friend rather than foe.
For more information download AMP's free guide