Learning from the professionals

Everyone knows (or at least should know) that financial markets go through cycles. The different asset classes such as stocks, bonds, real estate, commodities etc are not fully correlated and therefore may appreciate or depreciate at different times in the market cycle. Investors being aware of this uncorrelated nature of asset classes use it to determine which one is the best to invest in the current circumstances.

However, at times it becomes difficult to forecast which asset class is the most ideal for investing at a particular point in time. The reason for this is that some of the asset classes are not performing well and have a negative outlook, while at the same time the outlook for the other asset classes that are currently doing well, is uncertain.

This applies to the current environment as well. The outlook for most global stock, real estate and bond markets outside the Mena region (Middle East and North Africa) isn't strikingly positive. At the same time the commodity markets have had an extended bull run, making new investors wonder, if it is too late in the cycle for them to participate. Simply put, there is no single asset class which investors can wholeheartedly back these days.

To further complicate the situation, we are currently in a unique period. Normally, financial markets are negatively affected by economic crises. However, currently we are in a situation where global economies are being negatively impacted by the sub-prime crisis, which is in effect a financial one. What is adding to the uncertainty and therefore market volatility is that the extent of the sub-prime crisis has not been fully determined.

Investor's dilemma

As everyone is aware, the GCC economies are riding high on the back of an oil boom. The outlook for the economies of the Gulf and the broader Mena region continues to be positive. There is tremendous liquidity both at the institutional as well as the high net worth individual level. For those investors who have already invested in the region's equity and real estate markets and are looking to diversify their investments outside the region, the current environment provides them with very limited choice. The GCC investor therefore has the irritation (as opposed to a serious problem) of excess liquidity, but limited investment opportunity!

At this point, I must differentiate between individual and institutional investors. This is more of an issue for individuals as opposed to institutional investors. A recent study in the United States highlighted the fact that those asset classes that see significant institutional flows tend to be the ones that do well going forward. In contrast to this, everyone is aware that retail investors are notorious for getting their timing wrong and tend to invest in most asset classes at the peak of the cycle, and withdraw at the bottom of the cycle, instead of the other way around.

There are several reasons for this: access to timely information, superior resources and overall sophistication of institutional investors. However, in my opinion, there is one main reason: Individual investors tend to view their investment portfolios as a series of single investments. Each investment is made based on what the investor perceives is the best performing option at that point in time. Given that most retail investors are known to get their timing wrong, individual portfolios generally tend to be a collection of failed investments as opposed to success stories.

Asset allocation

Institutional investors on the other hand follow a different approach to building their investment portfolios. First and foremost they approach their investments on a holistic portfolio basis. They then make use of the simple but effective and powerful tool of asset allocation.

Asset allocation is an investment strategy that combines diversification with goal setting. An investor allocates specific percentages of a portfolio to different asset types such as stocks, bonds or money market instruments. They can then diversify further by choosing allocations among subclasses such as large/small-cap stocks or investment-grade/high-yield bonds to smooth out returns and maximize return/risk possibilities. Several concepts underlie the use of asset allocation including the relationship of risk and return, the risk of different asset classes, the level of correlation among assets and time diversification.

Skilful asset allocation can be an even more powerful tool when the risk and return attributes of several asset classes are combined. The original work on asset allocation, and the foundation of what is called Modern Portfolio Theory, was performed by Nobel Laureate Harry Mark-owitz, who showed that a portfolio using different asset classes can reduce risk without significantly reducing return.

The basis of asset allocation rests, in part, on the correlation (or lack of correlation) between asset classes. Different markets move in different directions: one year global stocks might be the best-performing asset class and high yield bonds the worst. The next year the high-yield bonds might be the best performing asset class and real estate the worst.

For example, over 15 years ending April 30, 2007, the correlation of total returns for the Lehman Global Aggregate Index with total returns for the MSCI World Index is 11 per cent.

Over the past five years, the correlation is -2 per cent. This non-correlated relationship means that the two asset classes, rise and fall independently of each other.

By successfully combining the two asset classes, a portfolio manager can increase the returns of each individual asset class while reducing volatility.

Simple solution

The good news for the individual investor is that they don't need to understand the technicalities of asset allocation. They do however need to appreciate the concept and try to change their approach to investing. There are several banks and financial advisers that can help them with build their investment portfolios using asset allocation tailored to their personal objectives, preferences and risk appetite.

Individual clients shouldn't be asking their financial advisers for the best product or asset class to invest in. They should instead be asking the adviser if they can help them build their investment portfolio in a manner that helps them achieve their financial objectives.

Sometimes the best way to get the right answer is to start by asking the right question!

- The writer is a senior director at Franklin Templeton Investments. The views expressed in the article are his personal opinion.