Don't try to pick and choose fund managers, choosing the asset class is the key

Published on Friday 10 October 2008 14:00

INVESTING money should be a simple game, but a frequent lack of common sense makes it more complicated than it needs to be.

The performance of an investment portfolio is determined by a combination of the mix of asset classes, the choice of investments within an asset class and timing. But while academics continue to debate the topic, most studies show that differences in investment returns are almost entirely driven by asset allocation and when, in terms of timing, these asset allocation decisions are taken.

Of the three factors above, the choice of investments within an asset class has the least impact on the overall performance of an investment portfolio. Yet, this is the area on which too many investors focus too much, looking for that elusive star fund manager who will out-perform the rest of the pack.

Despite this focus on finding the top-performing funds, the reality is that the worst-performing fund in the right asset class is likely to outperform the best performing fund in the wrong asset class.

Over the past year (at the time of writing) the best-performing UK Equity Income fund made a loss of 10.6 per cent. In contrast, the worst-performing index-linked gilt fund made a positive return of 7.4 per cent. It is interesting to consider whether investors in either of these funds would be happy with this performance.

Having established that investing in the right asset classes is more important than investing in the right funds, is there any way that investors can ensure they benefit by having larger weightings in the best performing asset classes?

Many financial "experts" try to predict which asset classes will perform well and which will perform badly. Some will use a vast array of economic data to come to their conclusions, while others use little more than guesswork. These "experts" may then suggest that investors construct their portfolios to take account of this information.

But what are the chances that you increased your equity weightings in the 1990s and then came out of shares just before the market crash at the beginning of the millennium? The former may be possible, but the latter is highly unlikely. At that time the industry was very positive toward equities, and technology stocks in particular.

Contrast this with the sentiment in March 2003 as stock markets bottomed. Very few investors increased their equity weightings at that time. The biggest selling funds in March 2003 were fixed interest, following a period of strong performance and just as equities were about to rebound. The reality is that some of the best periods often follow sharp falls when most people are put off further investment. In this example, from the bottom of the equity market in March 2003, over the next nine days there was a rise of 18 per cent, this being about 40 per cent of the total rise into the summer of 2004.

Once you accept that investment performance is predominantly dependent on asset allocation, and that nobody can reliably predict the future, you should aim to structure your portfolio to hold a broad spread of different asset classes so that, no matter what the outcome, your investments have the best opportunity of meeting your financial objectives.

&#149 Graeme Lind is a wealth adviser at Towry Law in Edinburgh.