by Stuart Fowler, Managing Director, Investment by Design and author of 'No Monkey Business: What Investors need to know and why'

Stuart Fowler, Managing Director, Investment by Design

Asset allocation literally means exposure to different types of asset, hence 'where your money is put to work'. It treats asset types (such as deposits, fixed income investments and equities) as 'building blocks' for assembling in simple or complex ways to achieve a customer's goals. Asset allocation is at the heart of the advice process, but is also the source of many challenges.

1. Distinguishing between asset types
The first challenge is therefore to describe the building blocks and distinguish them from each other. Though verbal descriptions may be used these are only likely to be accurate if they originate with numbers. The descriptions are distinctions about behaviour. Therefore the accepted numbers are mean expected returns, standard deviation or variance (which professionals accept as a definition of risk) and co-movement (when it comes to mixing building blocks this is what substitutes, as the relevant measure of risk, the overall portfolio risk for the risks of the individual assets).

2. Ensure accuracy of data
Distinctions exist and can be found in historical data. But the second challenge is what data? Observed data alters depending on what length of window is taken and whether a window is specific to particular but transient economic conditions, such as low or high inflation, low or high profits growth. Used blindly as inputs to a decision about asset suitability or an optimal mix, garbage in will produce garbage out.

3. Don't apply single numerical assumptions
The next complication comes from the fact that a single set of numerical distinctions should never be applied in all cases. Means and variances in money terms are not relevant as inputs to a decision about how to meet a target level of wealth in real (or purchasing power) terms. Risk based on one holding period is not the same for others. Risk for a given portfolio mix will be much higher for a lump sum investment than for a regular savings plan.

4. Make realistic projected outcomes
For projected outcome possibilities to be realistic, the assumed mean expected return should also be consistent with the portfolio values that act as the starting point in the projection. Average historical real returns for equities are around 6% per annum (in real terms) but when an investment is made in a market some twice the 'trend' level consistent with a 6% return, as in the late 1990s, the projected outcomes will be seriously overstated if that normal growth rate is applied to the above-normal portfolio value.

5. Take into account implementation choices
All asset allocation projection rates should take into account the likely or actual implementation choices. Product expenses should feed back into the planning assumptions, reducing the gross returns expected at the asset allocation level. The exposure to active-manager risk should be allowed to expand the bands of uncertain outcomes at the asset allocation level. Both make dramatic differences to real return probabilities so excluding them undoes all the good work of a robust asset allocation process.

6. Customers need to be involved in the decision making process
The nature of the relationship with customers changes when advisers articulate clear distinctions between strategies based on a complete range of probabilities. Customers no longer need to rely on an adviser as a proxy decision-taker and may become reluctant to do so. When they realise that the only way they can have both more certainty of outcome (such as being 99% certain of achieving a monthly pension in real terms of £2,000) and take less investment risk (no equities, please) is if they also make much higher contributions, they are unlikely to see that as a choice somebody else can or should make for them. Only the customer can imagine the personal consequences of a shortfall or make the trade-offs between targets, risk and resources that theory-based advice tools require.

7. Confront old habits
Once advisers start to work with the output of advice tools that capture all of these vital distinctions they will be forced to confront old habits. But it is not only their mindset that gets challenged: so does their business model. Active funds are necessary to earn high commissions but showing customers the impact of additional costs and risks on their asset allocation and resource planning may turn them off active funds. Helping customers to select an optimal balance of risky and risk-free assets may reduce the agent's earnings base for all but time-related fees.

8. Challenge the authorities
Formal asset allocation processes also challenge the authorities. The Treasury says the Sandler suite of lightly regulated products should be 'balanced' funds but if sensible real return descriptions for bonds are used as inputs to portfolio construction tools for long-horizon real-return investors, it becomes very difficult to show why conventional bonds are suitable, how they reduce the chance of extreme outcomes or make for more efficient portfolios. Since the Government is the main issuer of bonds, it is not a disinterested party. Advisers can be.

Finally, as practice adopts theory, the FSA will have to confront its own role as a Luddite. Risk tolerance is treated as being general to an individual but should be specific to each different task. The rules make suitability a function of each product but theory makes it a function of a portfolio of products. Standardised projection rates for products must be used so none of the distinctions outlined above can be put to good consumer use. Complete modeling of probabilities is not allowed unless the means and variances are similar to the standardised projection rates, so FSA estimation errors permeate the entire system. And how come, if asset allocation explains over 90% of the variance of portfolios, product selection processes are tied up in red tape but asset allocation is not even covered by the Financial Services and Markets Act?

Oh yes, it promises to be a very interesting journey!

About Stuart

Stuart Fowler has been in the investment business since 1969. He held senior management positions in two mainstream British fund management firms before setting up a successful international start-up, using 'quantitative' techniques for portfolio management.

Since 1996 he has acted as a business consultant to investment firms through his own company, Investment By Design. Consulting projects in retail financial services have focused on business model, process and use of 'investment technology'. He is the co-designer of the Fifth Freedom 'model' linking financial planning and portfolio management.

He is the author of 'No Monkey Business - what investors need to know and why' (FT Prentice Hall), a book that challenges the high cost and poor quality of retail investment products and services in the UK. No Monkey Business has its own website, http://www.nomonkey.biz.