Working model

4th September 2008

My IFA claims that what matters with my investments is the asset class allocation model he has created rather than the selection of underlying funds or stocks. Is he right?

He may well be correct. This is one of those interesting subjects that is receiving a great deal of attention at the moment.

If your IFA claimed that he could select the best investment fund or share, I guess that you would want him to provide some evidence of how he goes about achieving this. What systems and processes does he have in place to constantly research the funds or shares?

I have little doubt that the selection of appropriate funds is possible but I am a bit more reticent on the ability to constantly review the fund universe. After all, there are upwards of 2,000 collective funds available which would require a research department of some magnitude.

Of course, your IFA could be outsourcing the selection of investment funds to an independent third party but most thinking IFAs realise that they add value not by claiming to select the best funds but by selecting the most appropriate funds to match a client's needs.

If your IFA is not a stockbroker, then I guess the same reticence would apply to the choosing of individual stocks. As with all investments, that old adage about not keeping your eggs in one basket makes real sense. Of course, we just express it differently and talk instead about investment diversification which sounds much more professional.

There are a number of ways in which diversification can be achieved and the first one to explore is that being promoted by your IFA - asset class diversification.

Let us start with cash. This provides no prospect of capital growth but some degree of capital security.

Three things to consider are the combined impacts of tax, inflation and future variable interest rates although in the last 12 months or so, cash has not been a bad place to be for at least some of your money.

No doubt your IFA has recommended that some of your investments be held in fixed-interest securities such as corporate bonds and gilts. These provide the twin prospects of interest payments and potentially some capital gains. That said, looking back over the last year, these have been fairly flat.

Commercial property has taken something of a hammering in the last year but a portfolio with some element of this asset class will probably do quite well in the long term. Those who have held commercial property in their portfolios over the past decade have done quite well, despite negative returns in the past year.

Finally, no doubt your IFA has recommended some equity investments, both in the UK and internationally.

The value of these shares can rise and fall over time and so can any dividend income payable from them. This asset class is generally considered the one that offers the greatest prospect of long-term reward but it is also potentially the most volatile asset class.

I have to say I am in agreement with your IFA. I think it is better to have a spread of asset classes that matches your investment goals and objectives as well as your appetite for risk and reward. This asset class model then has to be put into effect by investing in funds or direct investments (or a combination of the two) and most of us would prefer to invest with a manager who has got it right in the past. There can, of course, be no guarantee of future performance, hence the risk warnings that are so prominently displayed.

The theory of asset class investment modelling is often debated and there is some doubt about its precision but I am reminded of a story that serves as a reasonable analogy.

Apparently, US Secretary of State Condoleezza Rice appeared in front of her team one morning and stunned them with a plan she had devised for Middle Eastern peace. So compelling was it that the only response she could get from her team was: "That would obviously work in practice but will it work in theory?"

Investment asset class modelling is similar as it seems to work in practice, it is just a question of whether it works in theory.

This article was first published by Money Marketing.

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