During periods of low growth and volatility, relative exposure to different asset classes is more critical to investment returns than active security selection or choice of investment manager. In this article, we discuss the benefits and philosophy behind a dynamic asset allocation (DAA) investment strategy.
DAA is used to actively adjust the split of investments across asset classes in response to expected market changes. In doing so, it provides diversification benefits in a portfolio but it also provides the ability to adjust allocations to help enhance performance.
A DAA investment approach offers the following:
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Targets real outcomes that generate long-term growth.
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Enables investors to find opportunities that capitalise on the ebbs and flows of the market cycle.
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Flexibility to shift investments in and out of asset classes to seek mispriced opportunities, free of the rigid constraints of static allocation portfolios.
Making the most of two investment fundamentals
Dynamic asset allocation helps investors make the most of two investment fundamentals: the power of compound interest and market cycles. Compound interest is simply the concept of earning interest on interest or, more broadly, getting a return on past returns. In other words, any interest of return earned in one period is added to the original investment so that it all earns interest or a return in the next period.
Markets are cyclical and volatility can last as long as a decade before subsiding. Cycles encompass normal business cycles that result in three to five year cyclical swings in share markets. They can throw investors off a well thought out investment strategy that aims to take advantage of long-term returns and they can cause problems for investors when they are in or close to retirement.
Rather than stick to their strategy of investing in higher return assets over the long term, investors can be spooked by volatility, as we have seen recently, and reallocate to ‘safer’ asset classes such as cash, thereby missing out on the long-term benefits of compound interest. To reap maximum benefits from compound interest, investors need to ensure they have an adequate exposure to growth assets, that they contribute early and often to their investment portfolio and find a way to avoid being thrown off by investment cycles.
There are essentially three ways to manage cycles:
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Ignore them
Adopt a ‘set and forget’ approach to asset allocation – this may be suitable for long-term investors but not for those who are older or have a short-term focus.
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Forecast them
Do this using economic forecasts – but this is difficult as the track record of economists’ point forecasts shows.
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Use rhyming elements to manage them
While investment cycles don’t repeat precisely, they do rhyme. Each cycle has common elements, e.g. downswings in equities are usually preceded by overvaluation, tight monetary conditions and investor euphoria. These rhyming elements can be captured and combined to provide warnings of swings in the cycles and hence are a solid foundation for an active asset allocation process – this is the dynamic asset allocation approach.
In the absence of rigid growth and defensive constraints, DAA can drive investment across a range of asset classes to exploit periodic mispricing between asset classes through the market cycle. These pricing disparities are common and it is within this inefficiency that real investment value lies, where the ebbs and flows of the market cycle present significant opportunities to generate performance returns.
Five things to keep in mind when making investment strategy decisions
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Invest for the long term, ignore the short-term noise
This is the best way to benefit from compound interest. Investors can develop a long-term plan to suit an investor’s level of wealth, risk criterion, tolerance to volatility and age. It’s important not to get distracted by short-term volatility or trends.
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Compound interest is an investor’s best friend
The higher the return, the greater the investment contribution and the longer the time period, the more compound interest works. To reap maximum advantage, ensure there is an adequate exposure to growth assets, contribute early and often to the investment portfolio and find a way to avoid being thrown off by the investment cycle.
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Diversify
The golden rule of investing – don’t put all your eggs in one basket. Investors are best placed to spread their investments across a mix of asset classes that best suit their long-term investment strategy and goals.
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Focus on investments offering sustainable cash flow
Don’t’ be misled by promises of high returns and low risk. If it is hard to understand or looks too good to be true then it’s best to stay away.
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Asset allocation is paramount
It’s easy to worry about an individual share investment or whether the fund manager is picking the right shares but the reality is, the key drivers of returns are the assets (shares, bonds, cash, property, infrastructure, listed/unlisted, onshore/offshore, hedged/unhedged) that an investor is exposed to. Managers using active asset allocation should stick to an investor’s long-term strategy while adjusting medium-term allocations to make the most of market opportunities.
Final thoughts
A DAA approach can be used to dynamically re-balance a portfolio away from asset classes where lower performance and higher risks are expected, and towards those tending to stronger performance or lower risks. This flexibility, along with the risk management capabilities of this approach, may make it attractive to investors in the accumulation phase who are looking for growth and to those who are nearing retirement and have the ability to withstand the potential for short-term volatility.
Source: AMP Capital
About the Author
Nader Naeimi
Head of Dynamic Markets
Nader Naeimi has more than 19 years of experience in Australia’s financial markets, including 16 years at AMP Capital. As the Head of Dynamic Markets, he is responsible for leading the Dynamic Asset Allocation strategy for the Multi-Asset Group, as well as other macro strategies and asset allocations for several AMP Capital funds.
Important note: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided.