Stock picking vs Asset allocation

It is often thought that one of the main roles of financial advisers is that they are stock picking gurus, that will help clients select a few shares, with great foresight, and these shares go to return handsome gains to clients. The reality is very different. Single stock selection makes up little, if any of an adviser’s role in helping a client construct their portfolio. The focus of a financial adviser is in the more mundane, but critical role, of determining a clients most appropriate asset allocation.

So, how does stock picking differ to asset allocation?

Security selection involves just that, picking individual stocks or equities as part of a portfolio based on a range of criteria, such as future earnings prospects or assessed valuation against its current market price, with a view to gain from future price increases. This approach can work and can provide significant returns, however, to borrow an economic phrase “there’s no such thing as a free lunch”. These portfolios may burn bright, but they will not burn long.

Significant opportunities for large returns are often accompanied by significant levels of risk, that are far greater than those of a well-diversified portfolio. A well-diversified portfolio is what is achieved when assets are allocated effectively across many different assets including equities, of both large and small companies as well as Australian and global companies. Most portfolios will also include an allocation to defensive sectors, such as cash and fixed interest securities (government and corporate bonds).

Diversification is the key to managing investment risk and aims to reduce the risk of one or more investments in a portfolio of having a period of poor performance, as other investments in the portfolio will likely be doing well to make up for the ones that may be having a weak period. Poor returns can be driven by macro factors, such as a recession or market shock or may be company specific, which can include scandals, legislative changes, CEO resignation or any number of unforeseen non-market events. All of which could impact returns in an adverse way in a portfolio made up of only a few single stocks.

Numerous academic studies have consistently shown asset allocation to be responsible for approximately 90% of returns for a portfolio, rather than investment selection. Clearly, for a portfolio to be sustainable and generate consistent returns to investors over mid to long-term time horizons, asset allocation is the critical decision.

How are assets allocated?

Effective asset allocation depends on the individual risk profile of an investor. This risk profile is determined by many factors including financial goals, time horizons and personal tolerance for investment risk. Once this is known, an investor can be provided with a portfolio specific to their needs and goals. Whether that includes the needs for a consistent income or desire for long-term capital gains, proper asset allocation across the available asset classes, in appropriate proportions, will result in a well-diversified portfolio that should deliver this for a client.

With online platforms that now reduce brokerage more than ever, it is important for retail investors to consider their motivations. If you intend to speculate on volatile securities such as crypto currencies and tech stocks and expect to get rich quick, take the success stories you see in your newsfeed with a grain of salt. If you intend on achieving your long-term goals of wealth creation to provide you with a better future, it is worth talking to an experienced financial adviser to tailor you an investment to help make these goals a reality.