For most investors, 2008 was a painful year, with many portfolios experiencing capital losses of anywhere between 30 and 70 per cent. As a result, large numbers of investors appreciate American humorist Will Rogers when he said, ‘I’m not so much interested in the return on my money as I am the return of my capital.’

Finding the best way to maximise returns and minimise risk is every investor’s goal, and careful asset allocation can go a long way towards achieving such a balanced portfolio. Asset allocation is the process of dividing investments among different types of assets (e.g. equities, bonds, property, commodities, collectables), with the objective of maximising gains while controlling any risks. In other words, it is about not putting all your eggs in one basket.

Alternative routes
The process can be split into two basic approaches. Strategic asset allocation involves choosing an appropriate mix of assets with the intention of holding these within a portfolio over the long term, and changing only when your main investment requirements alter, for example when you retire. Conversely, tactical asset allocation, although often springing from the same source, seeks to diversify across asset classes but the weightings reflect the current market views of the investor, rather than being focused on a particular long-term outcome.

Rob Pemberton, investment director at HFM Columbus, suggests, ‘Tactical allocation is more of an attempt to “maximise” returns, whereas strategic allocation aims to “optimise” or “smooth” returns. Which one you choose depends on the faith you have in yourself, or a fund manager, to correctly call markets.’

Of course, getting market timing right is no easy task, which is why most investors will prefer to go down the route of longer-term, more strategic planning. While market volatility is painful, the longer you remain invested, the less impact potential declines will have on your ultimate return. Recoveries, as many investors are no doubt already aware, can happen quickly, and if you sit on the sidelines until market confidence returns, it may be too late.

Spreading the risks
So when deciding on the percentage mix of assets to include in your portfolio, the key thing to bear in mind is diversification, the idea that risk should be spread out as much as possible to limit losses. For the average investor, this is probably best done via a managed fund rather than trying to balance a portfolio themselves.

HFM’s Pemberton suggests that a simple portfolio of equities, gilts, commercial property, gold and cash should give a smoothed return over the long-term. ‘Some asset classes, principally equities and commodities, are volatile, offering substantial gains but with the risk of equally large losses. Other asset classes, such as fixed interest, have a much more stable risk/reward profile, offering less potential gain while being much more likely to protect your capital.’

Recently, active asset allocation strategies have gained something of a bad name. But, as Pemberton points out, ‘Financial markets have been anything but normal over the past 18 months, witnessing a “once in a lifetime” banking crisis that has had inescapable consequences across all markets. We are unlikely to suffer this sort of meltdown again in the coming decades.

‘What is undoubtedly true, however, is that the concept of diversification was being incorrectly applied with too many “new” or “alternative” asset classes claiming diversification and non-correlation benefits that had not been fully tested in the past and proved illusory in practice.’

Moving independently
The concept of “non-correlation” is key to an effective diversification of assets. A fundamental justification for asset allocation is the notion that different asset classes offer returns that are not perfectly correlated. That is, they do not always show similar levels of performance, so by diversifying, investors can reduce the overall risk and have a portfolio that is more likely to meet their goals. If one asset class is falling in value, another, uncorrelated asset may be rising.

Since the credit crunch tightened its grip on global markets, even the most diverse portfolio has suffered simply because every asset class has taken a hit, but this does not mean that fund managers are ready to abandon established notions of the importance of asset diversification.

‘The principles of diversification still hold,’ argues Paul Niven, head of asset allocation at F&C: ‘Just because it doesn’t work over a 12-month period doesn’t mean that it doesn’t work over the long term.’

Setting the right goals
Individual investors, as well as diversifying their holdings to achieve a smoothed return over time, also need to consider their own needs. So, for example, an investor approaching retirement will be more inclined to hold a portfolio more biased towards fixed interest than equities, whereas an investor in their 30s would look to build a portfolio made up of riskier assets, such as overseas equities, that, over time, have tended to generate the highest returns.

According to Standard Life Investments, investors entering retirement need to reassess their medium-term asset allocation and consider inflation-linked securities, long-dated blue-chip corporate bonds and stocks and sectors with exposure to real assets, such as energy, water and gold.

Frances Hudson, global thematic strategist at Standard Life Investments, claims that ‘Investors need to be more discriminating rather than simply adopting a blanket “buy bonds” approach. Similarly, portfolios that favour pharmaceutical and leisure stocks will still benefit from the consequences of an ageing world.’

She adds, ‘Confidence that inflation will remain low and relatively stable is diminishing. As a result, there is a shift from nominal to real assets, as governments expand their balance sheets and deficits grow on the back of increased spending on pensions and healthcare. Investors taking a medium- to long-term view would do well to look beyond the end of the current business cycle and consider the likely characteristics of the next.’

Living in the new market
Nevertheless, investors will tend to focus on share-based investments as a core part of their portfolios, and they currently face a dilemma. Equities have fallen sharply, while government bonds have risen in price. According to Duncan Gwyther, chief investment officer at wealth management firm Quilter, ‘The question investors should be asking themselves is how much risk they want to take. Government bonds have been proving popular among the more risk-averse investors, and locking into a fixed coupon on gilts now could prove beneficial, but longer-term investors with more of a capacity for risk will find opportunities in equities.’

This theme is underlined by Virgin Money’s Investor Intentions Index, which tracks independent financial advisers’ confidence in the major investment sectors on a quarterly basis. The latest figures show that confidence in equity investments has dramatically revived in the past quarter, with 79 per cent of IFAs advising their clients to invest in UK shares over the next three months. This compares with just 57 per cent in February, when the FTSE 100 was heading downwards. The index also reveals that the renewed appetite for risk is reflected in a drop in intentions to invest in cash and bonds.

Virgin Money believes the sea change is due to the prospect of ‘green shoots’ in other markets, compounded by the poor rate of return on cash while interest rates remain low. The Bank of England reduced the base rate to a historic low of 0.5 per cent in March 2009 and has yet to change this position.

Virgin Money spokesman Grant Bather suggests, ‘Better returns now outweigh the relative security of cash investments. Investors quite rightly sought the safety of cash and bonds when banks were desperate to improve liquidity and equities were so unpredictable. But in the past three months confidence has started to return and, while there’s a long way to go, these are promising signs.’

Stock market revival?
A recent piece of research conducted by Newton Investment Management exploring the implications of the significant de-leveraging brought about by the bursting of the credit bubble, led to the conclusion that investors are now being fairly rewarded for taking risks for the first time in a long while.

As Helena Morrissey, CEO of the firm, points out, ‘This is the time when equities should be accumulated and when active asset management can be of great benefit. It is clear that those companies that can anticipate and adjust their approach to the aftermath of the credit crisis will emerge as the winners.’

Such confidence stems from the fact that, historically, the stock market has been positive much more than it has been negative and bull markets have tended to surpass bear markets, in terms of both their length and the fact that the total returns generated when markets are rising have been more than enough to offset the falls. Following each past bear market, stocks have eventually achieved new highs, and those investors who stuck with equities have been rewarded.

Recent weeks have brought some more rays of hope as stock market indices around the world have continued to rise, but the key issue still facing the global economy is whether or not the stimulus packages put together by numerous governments have generated sufficiently strong growth momentum. Will the global economy be able to stand on its own two feet if the stimulus is taken away now?

Holding your breath
‘Going forward, the longevity of the current sharp recovery depends on final demand,’ claims Bill O’Neill, portfolio strategist at Merrill Lynch Global Wealth Management. ‘The global fiscal stimulus may boost final demand through the summer, and the recovery in sentiment, as well as a stable corporate financing environment, should encourage capital expenditure. There is reason to be cautiously optimistic on final demand, above what currently prevails in the market.’

He adds, ‘There are a number of ways in which a bearish stance towards government bonds can be interpreted at the moment. A gloomy view would be that the sheer volume of supply is going to overwhelm markets and force yields higher, despite the obvious policy need for them to be lower. A more constructive view holds that the relative price of risk and liquidity is returning to normal, to the detriment of risk-free assets.’

And F&C’s Paul Niven echoes the view that a cautious approach should be considered by investors. ‘The moves in asset markets have, in many instances, been extraordinary, with the bellwether S&P 500 index moving up by 42 per cent from its intraday low of 666 points on 6 March and many emerging markets are showing even greater gains.

‘In contrast to equities, credits and commodities, government bonds have had a torrid time. Yields have backed up aggressively as inflation concerns have resurfaced, supply of paper has ballooned, creditworthiness of issuers has been undermined and the economy has returned from the dead.’

Such circumstances, however, create opportunities. Niven reports that ‘Here, however, bond markets are looking more interesting to us. We do not dispute that long-run valuations are poor, and we are certainly mindful of the inflation and rating risks associated with government bonds, but we feel that economic disappointment, ongoing risks of deflation and a likely desire by authorities to cap the rise in yields, which could derail the recovery, will help yields down in coming months.’

Many industry analysts, however, believe that real value is to be found in emerging markets. Bryan Collings, manager of the Ignis HEXAM Global Emerging Markets Fund, argues, ‘People view emerging markets as hugely volatile relative to developed markets and shy away from this perceived risk. But short-term volatility is more a function of portfolio flows from short-term foreign investors and speculators than an indication of fundamental risks. What’s more, relative volatility within emerging markets has actually been trending lower for years, including during this latest crisis.’

He points out that volatility in emerging markets has consistently remained within a narrower range than both the FTSE All Share and the S&P 500 indices. In the recent crisis, emerging markets’ volatility peaked at a significantly lower level than that of developed markets and dissipated more quickly.

Collings believes that misconceptions surrounding emerging markets are compounded by the huge disparity in investors’ knowledge of developed versus emerging markets, especially among UK investors. This creates a false comfort with UK equities and an unwarranted scepticism about emerging markets.

He adds, ‘The cost of acquiring sufficient knowledge about emerging markets is high and this precludes optimum portfolio allocation.

‘The majority of UK and US investors have approximately five per cent exposure to emerging markets within their portfolios. It makes no sense to have so low an allocation to such a large and important asset class.’

And chief among the emerging market economies is China. Byung Ha Kim, lead portfolio manager for the Mirae Asset China Sector Leader Equity Fund, suggests that now is the time to invest in this potential powerhouse, with the economy set to recover and achieve above eight per cent GDP growth in the second half of 2009.

‘The investment opportunities in China are attractive in both the short and the long term,’ Kim claims. ‘In the short term, China has one of the world’s strongest balance sheets and its 4,000 billion yuan (US$575 billion) stimulus package and loosening monetary policy is already having a positive impact on domestic consumption and investment demand.

‘Meanwhile, the world’s major economies are taking coordinated stimulus measures to greatly reduce any further unexpected shocks to the credit market.’