Principles of Investing for American Citizens Living in the UK: Principle Three - Devise a Strategic Asset Allocation
A key principle for successful investing is devising a strategic asset allocation in line with your investment goals and objectives. A strategic asset allocation refers to the target weightings for different asset classes within a portfolio, such as equities, fixed income, real estate, alternatives, etc.
“On average, 90 percent of the variability of returns and 100 percent of the absolute level of return is explained by asset allocation.” ~ Roger G. Ibbotson, Professor Emeritus in Practice of Finance, Yale School of Management.
A key principle for successful investing is devising a strategic asset allocation in line with your investment goals and objectives. A strategic asset allocation refers to the target weightings for different asset classes within a portfolio, such as equities, fixed income, real estate, alternatives, etc. Despite common misconceptions, your strategic asset allocation will tend to be the main determinant of your portfolio’s returns, as opposed to timing the market (buying and selling at the ‘right’ time) or picking the best stocks within an index. With the future being inherently uncertain and difficult to predict, positioning your portfolio for a specific event is usually a fools’ errand. Your strategic asset allocation should ensure you achieve your goal irrespective of future market conditions.
Your strategic asset allocation should consider the following:
1.) Risk vs reward:
a. Understanding that risk and return go hand-in-hand is one of the most basic but important principles of investing. Investors who own volatile investments are typically compensated by a “risk premium” but must accept greater volatility as a result. Your strategic asset allocation should be personal and tailored to your emotional risk tolerance, current and future financial needs, and investment time horizon.
a. Diversification is commonly referred to as “the only free lunch of investing” and is one of the cornerstones of successful investing. Ensuring appropriate diversification within a portfolio is key to maximising returns for a given level of risk. Considering your exposure to different asset classes, geographies, and currencies will be important for optimising the risk and reward profile of your portfolio through wide diversification.
a. Managing currency or exchange rate risk can be a complex challenge for American citizens living in the UK. A seemingly tax-efficient investment may pose hidden currency risks that could reduce purchasing power in the UK.
b. Holding US Dollar-denominated bonds or fixed income can add an additional layer of complexity to a portfolio. For instance, an American living in the UK may invest with a US Dollar lens, primarily for tax reasons, yet plan to retire in the UK and require an income of British Pounds in retirement. The adage of not “letting the tax tail wag the investment dog” has great relevance in this scenario because investors holding US bonds (i.e. bonds that are priced and pay income in US Dollars) will be subjected to the to-and-fro of currency markets; namely, the GBP – USD currency pairing. As the US Dollar depreciates, the value of your US bonds positions in the UK will also lose value, which can complicate capital preservation and income generation in retirement.
c. To effectively manage currency risk, one approach is to diversify bond or fixed income exposure away from the US, as a stream of coupon payments in US Dollars may not be appropriate for retirement. Instead, American citizens living in the UK should ideally match the income from their investments (typically derived from bonds or fixed income) with the currency of their future liabilities to protect against fluctuations of the dollar.
4.) Portfolio Rebalancing:
a. Defining an objective process for rebalancing your portfolio will be crucial for managing risk, capitalising on market dislocations or corrections, and keeping your emotions in check. A rebalance refers to the process of realigning the weightings of your portfolio’s investments with the target, where overweighted (or overvalued) asset classes are sold to purchase underweighted (or undervalued asset classes). It is commonly performed twice a year or when raising or adding capital to ensure the portfolio remains invested within the agreed risk parameters.
b. Agreeing on the parameters at the outset of any investment is important for ensuring a rebalance takes place, regardless of market conditions or sentiment. Systematic rebalancing of your portfolio can help automate contrarian investment practices (i.e. purchasing when others are selling) and ensure you capitalise on market dislocations when they take place.
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