4 investment principles for dynamic asset allocation
Principles that have passed the test of time to help you make investment decisions under a dynamic asset allocation approach.
The fundamental principle underpinning a dynamic asset allocation approach to investing is that just about everything in financial markets is cyclical. The key to understanding what drives stock market cycles is to recognise that there are concurrent cycles at play during any given time, from long-term cycles which are driven by valuations to short-term cycles which are driven by investor sentiment and central bank actions.
And while making investment decisions objectively is critical to success, objective analyses still need to pass the test of time – this means they must be underpinned by a set of fundamental investment principles. The following principles are engraved within our dynamic asset allocation investment process and we believe should be taken into consideration by all investors:
- Risk is not the same as volatility – risk is the potential to lose money and not recover; volatility is a backward-looking measure at how variable an asset is. Therefore, price risk should be a stronger focus than backward-looking analysis.
- Risk and return are different sides of the same coin – there is often more downside to investing in high performing, expensive and popular companies with low volatility than the apparent low performing companies with high volatility. This is due to the critical role ‘investor expectation’ plays, where the expectations on high performing companies become increasingly hard to meet. Similarly, expectations on the unpopular companies are low and hence become easy to beat.
- Diversification based on historical correlation is destructive – correlations can change; typically increasing during economic instability. Overcrowding and the typical overpricing of popular investments leads to high correlation when the economy turns and investors decide to sell at the same time. Therefore, the diversification benefits that are crucial during these times aren’t received. Smarter diversification can be based on how assets are valued and how crowded the positioning is, rather than relying on historical correlations.
- The market cycle leads the economic cycle – if you aim to buy assets when the economic cycle is strong and sell them when it’s weak, you will inevitably miss out on opportunities and be exposed to risks. History has shown us that weak economic conditions don’t always lead to weak future share market returns. At the same time, it would be unreasonable to assume that the macroeconomics and earnings impact on future market returns is insignificant. Indeed, a sustained and durable move higher in shares requires strong support from earnings growth and a healthy macro backdrop, but the macro impact at turning points is often counter intuitive.
About the author
Nader Naeimi is the Head of Dynamic Asset Allocation at AMP Capital. With over 16 years’ experience in Australia’s financial markets, including 12 years as part of AMP Capital’s Investment Strategy and Economics team, Nader’s responsibilities include analysis of key economic and market factors influencing global markets.