February 2008

Asset allocation...

Any proponent of a medium to long-term investment horizon will fully endorse the benefits of a sensible asset allocation. Asset allocation can improve both diversification and performance, although at times, these aims could conflict as different asset types and sectors move in and out of favour.

Above all however, any proposed asset allocation should always be relevant to the investor's current risk profile, investment and income requirements and there should also be a consideration for the investor's tax status.

The reasons why good asset allocation improves diversification should be fairly obvious. It helps ensure that investments are spread out across a wide range of markets and securities, and the allocations should be chosen to avoid investing too much in markets and securities whose movements are strongly correlated with each other. Asset allocation can boost performance by identifying markets or sectors that are undervalued as a whole and correctly identifying these will clearly improve performance. These regions and markets are also more likely to contain individual securities that are undervalued.

Investors can reduce risk and improve the level of risk relative to return, by diversifying their portfolios. Diversification moves investors closer to what is known as the efficient frontier. The efficient frontier describes the relationship between the return that can be expected and the level of risk (volatility) of the portfolio. It is typically illustrated as a curve on a graph of risk plotted against an expected return. In effect, it summarises the point that the higher level of risk an investor takes, the higher the potential level of return.

The key to diversification is to choose investments whose prices are not strongly correlated. Although some financial institutions use sophisticated financial models to calculate and control risks, good diversification can be achieved with little more than reasonable common sense. Firstly, investing in different sectors, geographical regions and classes of security improves diversification: the values of shares, bonds and pieces of real estate will be more correlated with each other than with investments of completely different types.

Investors who start from the highest level, making decisions such as deciding how much to invest in different classes of investments (such as equities, bonds and property) and in which regions around the globe, are known as 'top down' investors. The final step in this approach is to decide which collective scheme or individual security. Conversely, investors who initiate their investment decisions with their choice of security and build up sector and country exposures are known as 'bottom up' investors.

At Origen, we believe that investors who construct a well diversified investment portfolio which fits into a sensible asset allocation will deliver sound returns over the medium to long term. Over recent times, we have seen a number of 'hot areas' of the market that have attracted huge sums of money on the back of excellent returns. Undoubtedly many investors would have enjoyed the success of these, however we would continue to promote the benefits of diversification; do not keep all of your eggs in one basket!

John Monaghan
Investment Manager
Origen