The portfolios Asset Allocation is paramount
The appropriate allocation of capital among asset classes (shares, bonds, fixed interest, etc ) will have a greater influence on long term portfolio returns than the selection of individual securities. Asset classes are a group of securities that share similar characteristics such as
- Investment type – Shares, bonds or property
- Geography – Domestic or International
- Strategy – Small company, value company, profitability
Diversification reduces unnecessary risks
Unsystematic or company-specific risks can be dramatically reduced through appropriate
diversification, enabling the portfolio to principally be exposed to market, or systematic risk.
Diversification is enhanced by holding the majority of available securities within an asset class and including multiple asset classes (such as international shares and bonds) within the portfolio.
Higher returns are achieved by taking more risk
Generally, and in the long-term, to achieve higher returns an investor needs to take more risk. As shares are riskier than bonds, we expect shares to have a higher return than bonds in the long term. Therefore, to achieve a greater return a portfolio needs a higher proportion
of shares relative to bonds.
Portfolios can achieve higher returns by tilting to risk factors
Academic research by Ken French and Eugene Fama have identified that there are equity and fixed income dimensions that have higher expected returns. Their research showed that:
- Small companies outperform large companies
- Value companies outperform growth companies
- Profitable companies outperform non-profitable companies
Tilting portfolios to these factors increases the portfolios expected return.