Some Considerations with Asset Class Allocation
Risk management is certainly a central component of asset class allocation in a mutual fund portfolio, but there are other considerations as well. Determining how much risk a client is willing to tolerate does play a big role in deciding all of this though, and this is why we seek to go into some detail when it comes to determining this.
Since mutual funds are typically longer term investments, particularly those that have a significant growth component, it is important to set up these portfolios in such a way that will allow investors to stay the course and not wish to exit their positions because the portfolio was not structured properly.
This of course includes looking to avoid them getting uncomfortable with the amount that one’s investments may decline in value, even though their present value may not be that pertinent to their objectives.
If you’re planning on holding an investment for 10 or 20 more years, what it can be sold for now doesn’t really matter at all, but many people still look at their investments and judge them as if they were to be sold now. This is a mistake of course but one that can be difficult to prevent a lot of clients from making.
It’s not just that you don’t want to see them do the wrong thing and sell their investments prematurely, or switch funds in such a way as to not make a lot of sense or even harm their objectives, we also don’t want to see clients become overly stressed with these issues either.
Part of the plan is to seek to educate them into understanding that long term investments undergo an ebb and flow and the particular strategies that are used to put together these long term investments are not even designed to be very reliable in the short or even medium term.
Rather, it’s the long term that they are shooting for and this is what is relied upon and what has delivered the results in the past and is expected to continue to do so. When we put this together with the fact that the price of a mutual fund only matters when it’s sold, this can serve to foster a better understanding of the way that these investments are supposed to work and how they should be managed.
Mutual fund agents generally don’t spend much time on this though, and they may suffer from a lack of understanding themselves to some degree, so clients often do not come away with a very good understanding of this at all. There are people who even check the value of their portfolios daily when the time frame for selling is many years away, and get upset when things don’t just move ahead in a manner they wish.
It’s All About Asking Questions
Getting a feel for the risk tolerance of a client is an important driver of asset class allocation, and you want to be asking specific questions like how uncomfortable they may become with a specific decline in their portfolio.
There are guidelines in place which will seek to determine which category an investor’s risk tolerance is in, although these categories tend to be on the broad side, for instance a low, medium, or high risk tolerance. Depending on the answers, investors will be placed in one of these categories and this will influence what types of investments will be recommended, starting with what proportion of each asset class will be considered to fit their profile.
A lot of investors tend to be put in the medium risk class here, and there can be quite a bit of difference between one medium risk investor and other, and this is too important of a matter to paint with a broad brush like this, but at least an attempt is usually made to assess this and usually keep investors from going with proportions that are clearly not suited to them.
It is also important to ask about what sort of return is being sought by a client with their mutual fund investments, as this can also get people uncomfortable and even cause them to make the wrong decisions and exit too soon due to not being happy enough with the amount their investments may be up at a given point in time.
These objectives may or may not be realistic, and just like risk tolerance, we must seek to educate clients at least somewhat to ensure that their expectations are even achievable. This starts by looking at the past returns of funds during the time frame sought by the investment as well as explaining that this especially does not mean that the fund will always move in the direction you like during shorter intervals of time.
There are even more clients that complain about the underperformance of mutual funds than there are with people being upset about being down, and they also tend to blame the agent who sold them the fund or the institution that sold it, even though they are just agents and have nothing to do with the fund’s performance.
The fund may be very appropriate for a client and may be even performing as expected but in a way that may be too tame for a client’s preferences. It therefore is important to properly assess these expectations and have the client modify them as needed prior to the sale, instead of having to apologize later and perhaps lose their business. Sometimes this cannot be avoided but it’s best to seek to set people up as best you can to avoid disappointment when possible.
Matching Asset Classes with Investor Time Frames
Perhaps the most important consequence of determining the appropriate mix of asset classes for an investor is ensuring that this corresponds properly with the desired investment time frame of a client.
Those who seek short term time frames aren’t going to want to have much of a growth component in their portfolios, because these investments deliver results over the long term, or at least this is the strategy that mutual funds take with them.
If the strategy is long term investing, and you’re investing in the short or even medium term, this will result in a mismatch of objectives which will introduce too much risk into the investment.
In some cases, with short term investments, having all of your funds in a savings vehicle may be the only sensible choice. A combination of bonds and savings may make sense if the time frame is a little longer, long enough where it is likely enough for the overall investment to be up, and if even more time is available, various amounts of growth class funds may be appropriate.
Time frame is the starting point in determining asset class allocation, as if the investment does not match the time frame of the investment properly, this will exclude other considerations. If the allocation does fit the time frame, then we can look at other issues such as one’s risk tolerance and investment objectives to further define the allocation, but only to the extent that the time frame fits.
Determining the proper asset class mix in a mutual fund portfolio is very important to not only the success of the investment, but to the perceived success of it by the client, and perception is often reality. The goal of investments is not only to do what is best for clients but to take their preferences well into account, and an appropriate recommendation of the mix of asset classes can go a long way in achieving this if properly done.