On one hand, you have those who are willing to take on a higher level of risk with their cash in the hope of making higher returns. They tend to chop and change their portfolio frequently as investing becomes a bit of a hobby.
The second kind of investor is the one who wants a portfolio that they do not have to constantly monitor and that can also protect their hard-earned cash – effectively long-term buy-and-hold types.
The key to the latter strategy is making sure that your portfolio is as diversified and uncorrelated as possible, so that if one sector – say emerging markets – were to crash, it wouldn’t wipe you out.
Experts agree that asset allocation is traditionally the principal driver of returns in the long-run; however, given the supercharged volatility in most areas of the market since the credit crunch in 2008, building an uncorrelated portfolio has become easier said than done.
Kames Capital’s Stephen Snowden says the entire balance of risk/return has shifted and so has the way markets behave.
"After Lehman Brothers, the percentage of portfolio variance explained by risk-on/risk-off jumped to almost half," Snowden (pictured) said. "In other words, a single global risk-premium dominated the price-behaviour of all equities, government and corporate bonds, listed real estate and commodities. Therefore it didn’t matter what you bought and sold, just as long as you bought and sold at the right time," he added.
That has put pressure on anyone trying to put together a diversified portfolio, because if there is a correction in the market, everything you own will take a hit.
You only need to look back at Ben Bernanke’s comments in May about the US Federal Reserve tapering its quantitative easing programme to see that the risk is very much there. In the resulting fall-out, the price of global equities, bonds and commodities – especially gold – fell in value.
This graph highlights this correlation, showing that the performance of the UK equity market, the UK corporate bond market, the UK sovereign debt market and the price of gold bullion all moved in tandem since the beginning of May this year.
Performance of indices since May 2013
Source: FE Analytics
Nevertheless, Bestinvest’s Jason Hollands says investors should not give up on the concept of asset allocation and that building an uncorrelated portfolio is still possible.
"The key to investing is that the biggest driver of returns has been asset allocation, not stock selection. There have been endless academic studies undertaken to prove this," Hollands said.
"However, since the credit crunch, there has been a high correlation between asset classes, which we feel has come about from the extraordinary actions from the world’s central banks. Their intervention has had a distorting effect, whereby all asset classes across the range have reacted to policy or the expectation of policy."
"If you take that view, then a strategy of asset allocation won’t have added any value over the last few years. However, at some stage, markets will normalise and asset allocation will once again drive returns," he added.
Thomas Becket (pictured), manager of the Psigma Dynamic Multi Asset fund, agrees with Hollands about the recent correlation of asset classes.
"June nearly put me out of a job," he joked. "Japanese government bonds seemed to be the only ones that didn’t go down in price. Asset allocation has been pretty difficult, but looking forward I think markets will normalise." "For the moment, however, being diversified across a number of asset classes is the best way," he added.
Hollands says that long-term investors should construct their portfolio starting from an asset-allocation point of view, even if financial markets remain correlated in the short-term.
However, where do you start?
Hollands says that investors should first decide on their equity exposure before anything else.
"The first starting point is to decide how much you are willing to hold in equities, because while they offer a higher return profile, they come with greater volatility," he explained.
"Once you have decided on that, then you look at fixed income and other add-ons. These could be asset classes such as private equity, commercial property, hedge funds or absolute return portfolios."
Hollands says that investors who think they have the right balance between equity and fixed income need to make sure they are properly diversified within these asset classes, or else one sell-off could cause all of their holdings to fall in value.
"When looking at your fixed income exposure, you need to look at duration or whether you want to be in corporate or sovereign debt," he added.
Duration is a measure of interest rate risk; therefore managers who are concerned that interest rates will rise in the short-term buy low-duration bonds, which will reach their maturity date within three years or so. This means they can reinvest their capital in higher-yielding debt instead of having to offload current bond holdings first.
Hollands says management style is the next piece of the puzzle, as different managers – for example growth or value ones – will outperform in different market conditions.
"When investing in equities, investors need to decide on which style of manager they want. For instance, you don’t want to be fully invested in either value managers or growth managers."
"There needs to be a sense of balance," he added.
So, what does a diversified portfolio look like?
Portfolio construction all comes down to an individual’s preference and their appetite for risk.
It is possible to look at some of the options for the different types of funds Hollands mentions.
Taking a look at equities, one of the best-performing value managers in recent years has been Alex Wright.
According to FE Analytics, his five crown-rated Fidelity UK Smaller Companies fund has returned 232.05 per cent over the past five years, beating both its IMA UK Smaller Companies sector and Numis Smaller Companies ex IT index benchmark by more than 100 percentage points.
Performance of fund vs sector and index over 5yrs
Source: FE Analytics
Fidelity has recently closed the fund. However, investors can still gain access to Wright’s strategy via his Fidelity Special Values IT.
Continuing with the value style, investors may want to consider outperforming funds from Standard Life’s Ed Legget and JO Hambro’s Alex Savvides and there is also a wealth of value managers that focus on areas such as emerging markets, North America, Europe and Japan.
For exposure to strong equity growth, Hollands tips Finsbury Growth & Income IT and the five crown-rated Jupiter European fund, run by FE Alpha Managers Nick Train and Alexander Darwall, respectively. Both have solid long-term track records.
For fixed income exposure, investors who want a bond fund that is not going to feel the shocks from an inevitable interest rate rise could turn to AXA Sterling Credit Short Duration Bond. If they are looking for something more diversified, FE Alpha Manager Richard Hodges maintains low duration in his L&G Dynamic Bond fund.
FE Alpha Manager Richard Woolnough has been one of the best-performing corporate bond managers and represents one option for investors looking for traditional fixed income exposure. Both his M&G Corporate Bond and M&G Strategic Corporate Bond funds have registered top-quartile performances over five years.
For something a little more exotic, Investec Emerging Markets Local Currency Debt offers investors a good level of yield, at 5.96 per cent.