17 September 2007
By Tim Hewson
In the last edition of Positive Interest we focused on tips for the confident investor. Since then, the paradigm of the investment landscape has changed considerably.
We invest in vibrant times
Offshore, the US Federal Reserve Board reduced the discount rate by 0.50 per cent to "promote the restoration of orderly conditions" to the market.
Triggering this was the long term pressure of the US housing market and the losses caused by the US sub prime market collapse. In fact, the real concern should be that so far the market has only been able to account for an estimated US$10 billion of the Federal Reserve Chairman's US$100 billion loss estimate.
To muddy the waters further, the Reserve Bank of Australia increased interest rates from 6.25 to 6.50 per cent. The long term bullish equities market also suffered its biggest weekly loss in 32 years, losing 11.9 per cent and leaving investors shell-shocked.
Add to this the growing concern over the global trend towards 'decoupling' from the US, an increasingly volatile Australian dollar, rising inflationary pressures and the forthcoming election - investors can't be blamed for thinking 'gee, what's next?'
Know your pain threshold
Unfortunately even the most sophisticated investors only react once triggered. And only then do they begin to wonder whether they've correctly allocated their assets, sufficiently hedged, or query whether their portfolio is diversified enough.
In the constant struggle between risk and return, it's normally an investor's appetite for short term return that triumphs over adopting a measured approach to risk aversion. For many investors, risk can mean very different things, and it's imperative that you know your risk profile.
How to develop your game plan
As a starting point, confident investors should take a calculated approach to developing strategy. This doesn't mean resorting to a calculator before making every investment. But as a minimum, have an accurate picture of what short term losses you can wear in order to potentially gain long term peace of mind.
Importantly, setting a realistic investment return objective and giving serious thought to loss potential will help decide what asset allocation might be appropriate. This is important, as an investor's resilience to their overall investment strategy during times of market dislocation can either generate the opportunity for quick pain, or broader gain.
Asset allocation
Asset allocation allows investors to combine a mix of assets that delivers the greatest chance of achieving objectives. The importance of the mixture is based on the assumption that diversification across asset classes can generate non-correlated returns and also reduce overall return volatility risk.
So if you determine managed funds to be part of your asset allocation, firstly define your investment horizon, set yourself a reasonable investment return objective and then decide on what asset classes and investment strategies suit you. And then research, research, research.
The advantage of portfolios with a long term view is that they allow you to set long term objectives, then fine tune allocations as required. So while short term investors might be restricted from taking advantage of cyclical market movements, long term investors can potentially benefit by altering their exposure during changing conditions.
Strategic asset allocation (SAA)
Strategic asset allocation is normally a long term process requiring investors to first understand their risk tolerance and investment horizon, then set an appropriate return objective to match. Investors can then implement a top down approach to constructing a portfolio across a range of asset classes and fund managers that best meets their objectives.
Dynamic asset allocation (DAA)
Against the backdrop of SAA, this plan lets investors make medium term changes to their portfolio so they can adapt to perceived market movements. DAA effectively allows investors to rethink their allocations within the context of changing market conditions and possibly make minor changes to the initial SAA of the portfolio.
DAA can either be opportunistic or defensive and is most suitable when looking at long term cyclical market movements.
Tactical asset allocation (TAA)
Tactical asset allocation changes are usually short term, deliberate and implemented by investors wanting to exploit perceived market inefficiencies. This doesn't necessarily mean deviating from initial long term objectives, or even changing the framework of SAA, but it does allow investors to take advantage of opportunistic investments and strategies when they arise, whether they are defensive, or speculative.
It is worth noting that historically, investor behaviour has shown they are twice as likely to make a TAA change to make money as they are to protect it.
Every action has an opposite and equal reaction
The important thing for an investor to remember is that there is a consequential relationship between risk and return. If a particular managed fund or investment strategy is focused on generating higher returns, it will also generate higher risk. Whilst this might be appropriate for the more aggressive growth allocations of a portfolio, it is unlikely that it will suit a defensive strategy where an investor might wish to protect their capital in the event of market dislocation.
Ultimately, as a confident investor you should feel comfortable knowing you've done your research. This includes:
Establishing a suitable objective and time horizon;
Diversifying across the appropriate classes;
Selecting suitable fund managers and strategies that consider possible periods of market volatility.
But should you find you're getting a little restless, you can still roll over and change your SAA, DAA or TAA to ensure you don't spend a night staring at the ceiling.
Thanks for reading, see you next time.
Happy investing.
