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Not so long ago, a firm of stockbrokers was making an absolute killing for its clients.
Annual returns of 50% or more weren’t uncommon...
Now Madoff only promised about 10% a year, so these guys must have been really special!
But pretty soon clients were suing the broker for millions. The broker very nearly paid the ultimate price for ignoring the cardinal rule of investing.
So what had they done?
They’d ignored Asset Allocation (AA). A friend of mine joined them at the time and he gave me the inside track. I’ll explain about Asset Allocation and what he told me in a minute.
In my last issue I said that AA is the most important factor in getting the risk/reward balance on your portfolio. In fact, I’d go as far to say that it could mean the difference between success and failure for your retirement fund...
As this firm of stockbrokers found out, it literally is criminal to ignore it!
How they nearly blew themselves up
Traders talk about ‘blowing clients up’. It’s when they make some stupid investments on the behalf of a client who then winds up bust. Well this firm blew up so many clients that the clients tried to put a bomb under them.
I can’t reveal the broker - my friend still works there. But I can say it is involved in ‘discretionary fund management’ where they choose and manage the investments on a client’s behalf.
Everything started off fine. They built client portfolios using classic AA. That is, they put the client cash into different asset classes right across the globe.
Asset classes include things like stocks, bonds, property, or commodities...
The problem turned out to be that this firm was particularly good at finding great high-tech stocks. And during the late nineties, this was the place to be. And this was the broker to be with.
Some stocks were growing at double digits month on month and clients were having a whale of a time.
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But portfolios were getting out of kilter...
What started with say a 40% allocation to stocks, ended up with something like 90%, or 95% in stocks by the year 2000. And worse, many of the stocks were in the technology sector. I bet you can see what’s coming next...
The dotcom crash crushed these ‘stock-heavy’ portfolios.
Stocks fell for two years and loads joined the ‘95% club’ having lost 95% of their value.
Clients (rightly in my opinion) took the broker to court claiming negligence. Why on earth hadn’t they re-balanced AA as portfolios became skewed?
Most cases were settled out of court and the broker managed to struggle on... Just.
The only free lunch in the City
They tell you there’s no such thing as a free lunch. But that’s not strictly true.
Diversification is just about the only free thing you’ll get in the City. And the only way to achieve meaningful diversification is by starting with AA.
Many investors get diversification wrong. They think it’s just getting a range of stocks and investments.
But it’s much more than that. You have to look at the over-all balance of asset classes. And by this I mean you’ve got to look at all your assets together... retirement funds, other savings and property.
This is something many advisers miss.
I reckon, if this broker had regularly looked at clients AA and rebalanced their portfolios, they wouldn’t have been found negligent. They would have cashed in some profits from the tech winners and moved it into other asset classes. They still would have lost a load on tech-stocks, but it could have been excused as just poor management.
By letting AA get out of control, they’d been negligent... it really was criminal.
Putting things right
What we really want are asset classes that aren’t correlated. So, for example, in the last few months bonds have been doing pretty well, even as the footsie has fallen. A portfolio diversified between stocks and bonds will have suffered less turbulence than one skewed towards stocks.
Even during the financial crisis of 2008 as most asset classes tumbled, some classes still headed up...
Cash (particularly in safe currencies) and precious metals provided sanctuary and diversification. That’s what’ll save a portfolio during turbulent times...
Later in the week I’ll be looking at some examples of AA and how to get the risk/reward balance right for you.
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Your capital is at risk when you invest in shares - you can lose some or all of your money, so never risk more than you can afford to lose. Always seek personal advice if you are unsure about the suitability of any investment. Past performance and forecasts are not reliable indicators of future results. Commissions, fees and other charges can reduce returns from investments. Profits from share dealing are a form of income and subject to taxation. Tax treatment depends on individual circumstances and may be subject to change in the future. Please note that there will be no follow up to recommendations in The Right Side.
Managing Editor: Theo Casey. The Right Side is issued by MoneyWeek Ltd. MoneyWeek Ltd is authorised and regulated by the Financial Services Authority. FSA No 509798. http://www.fsa.gov.uk/register/home.do
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Bengt Saelensminde
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