By Fisher Investments UK
A great body of scholarly research suggests asset allocation—the proportions of equities, fixed interest, cash and other securities in an investment portfolio—is a large determinant of an investor’s long-term returns. But how do you choose an asset allocation? In addition to risk tolerance, we think it is also important to consider long-term goals, ongoing cash flow needs and investment time horizon, which Fisher Investment UK define as the length of time your money must be invested to reach your goals.
We think it helps to define your investment goal as the primary purpose for your money. People can have varying individual wants and needs, but in our experience, they often boil down to one or both of two primary over-arching goals: growing their investments over time or generating cash flow on an ongoing basis. Consider what you want your savings to do. In retirement, is your main aim to not outlive your money? Would you like to maintain your current lifestyle or improve it? Maybe you want to increase your wealth as much as possible to give to your heirs or charity? Do you need your investment to generate cash flow to supplement the state pension? Or do you perhaps want to assist with a child, grandchild or other family member or friend’s education?
Writing down all the things you want to do with your investments, then bucketing them into “growth” and “cash flow” categories, may help you determine your primary purpose. When doing so, don’t forget to consider the effect of inflation. Since prices generally rise over time, you may discover you need some growth to generate adequate cash flow throughout your retirement. Of course, circumstances and goals change, which is why investors may find it beneficial to review their plan—and asset allocation—to make sure they are headed in the right direction.
Defining investment time horizon is also important. We often encounter financial commentary suggesting investors’ horizons end at retirement, when they shift from saving for retirement to spending in retirement. Yet, in our view, this ignores the likelihood their portfolio must earn some sort of return to generate the cash flow they desire. This generally extends their time horizon beyond their retirement date, to encompass the entire time they need their portfolio to help provide for their needs. As a result, many investors may determine their investment time horizon is their entire lifespan. It could even be longer when considering bequests to a spouse, children or an organisation.
According to the Office for National Statistics, a 65-year old man averages around 18.5 more years of life and a woman 20.9 years. At 65, you also have a decent shot of hitting 100—about a 1 in 10 chance. With continual medical advances and life expectancies rising, a new or soon-to-be retiree’s retirement savings could need to last for decades. Then again, even if you have several decades ahead of you, your money’s investment time horizon could be short if you have earmarked those funds for a near-term purpose, like purchasing a home.
After you determine what you want your money to accomplish and the investment time horizon to do it in, you can determine the asset allocation mix likely to achieve your plan. We think a helpful way to narrow this decision is to understand the tradeoffs between equities and fixed interest securities. Historically, equities have had higher returns over long timeframes than fixed interest, with less variability. But over shorter periods, equities’ returns are far more volatile.
To see the tradeoffs, consider historical returns of Global Financial Data, Inc.’s GFD World Index (a broad basket of equities domiciled in the developed world) and Developed Countries Government Bond Index since 1926. Over all rolling 30-year periods, equities achieved an average annualised return of 11.5%, with a standard deviation of 1.6%. Standard deviation is a measure of volatility that shows how much returns have historically varied from their long-term average. The lower the standard deviation, the lower the volatility. Fixed interest returned 7.0% annualised over rolling 30-year periods, with a 2.7% standard deviation. On a rolling 20-year basis, equities averaged 11.0% annualised returns with a 3.5% standard deviation and fixed interest averaged 6.8% annualised returns with a 3.1% standard deviation. Equity returns have higher volatility over rolling 20-year periods than fixed interest, but not by much. Over rolling five-year periods though, whilst equities’ average annualised return is 10.3%, standard deviation jumps to 8.0%. Fixed interest’s annualised returns are 6.7% over rolling five-year periods, whilst their standard deviation is 5.7%, significantly below equities’.
Since fixed interest has historically experienced smaller swings over shorter periods, investors with shorter investment time horizons may find it beneficial to have a larger portion of their assets in fixed interest than investors with longer time horizons. Someone looking to buy a home within the next few years may decide it makes most sense to keep their down payment amount in cash, rather than equities or fixed interest, to keep market volatility from preventing them from being able to make the purchase. Conversely, those with longer time horizons may find a larger weighting in equities is a better match for their needs, especially if their goals require their investments to grow over time.
We think it is also important to consider risk tolerance, which we define as the ability to emotionally withstand short-term declines. If an investor isn’t comfortable with equities’ inherent ups and downs, they may run the risk of making ill-timed portfolio moves, jeopardising long-term returns. They might find a blend of equities and fixed interest is better for them even if they have a long time horizon and their objectives centre on long-term growth.
In financial markets, reward is inseparable from risk—it is one of the iron laws of finance. Understanding how they relate to each other—as well as to you and your personal circumstances—can help shape your portfolio’s asset allocation to your financial goals and needs.
Investment management services are provided by Fisher Investments UK’s parent company, Fisher Asset Management, LLC, trading as Fisher Investments, which is established in the US and regulated by the US Securities and Exchange Commission. Investing in equity markets involves the risk of loss and there is no guarantee that all or any invested capital will be repaid. Past performance neither guarantees nor reliably indicates future performance. The value of investments and the income from them will fluctuate with world equity markets and international currency exchange rates.
iOne prominent example is: “Long-Run Returns on Stock and Bond Portfolios: Implications for Retirement Planning,” Kirt C. Butler and Dale L. Domian, Financial Services Review, 1992/1993.
iiSource: Office for National Statistics. National life tables, UK: 2014 to 2016.
iiiIbid. “What are your chances of living to 100?” 14/1/2016.
ivSource: Global Financial Data, Inc (GFD). Average annual rate of return from January 1926 – December 2017. Equity return based on GFD’s World Return Index in GBP. The World Return Index is based upon GFD calculations of total returns before 1970. These are estimates by GFD to calculate the values of the World Index before 1970 and are not official values. GFD used specified weightings to calculate total returns for the World Index through 1969 and official daily data from 1970 on. “Annualised return” refers to the annual rate of return that corresponds to the cumulative return over the entire period. “Standard deviation” represents the degree of fluctuations in historical returns.
vSource: Global Financial Data, Inc (GFD). Average annual rate of return from January 1926 – December 2017. Fixed Interest return based on GFD’s Developed Countries Government Bond GDP-Weighted Return Index and converted to GBP.
viSee note iv and v.
viiSee note iv.
viiiSee note v.