Rules of Thumb

In our formative early years, we are taught about rules of thumb especially when it comes to spelling.  They are effectively mental shortcuts.  For example, i before e except after c, u after q etc.  Of course there are some challenges when names such as Qantas come along, growing out of abbreviations.  We also see some novel ways of spelling children’s names.  It only gets worse when txt spelling is accepted for everyday use.

Without the ability to use experience based rules, we would spend a long time analysing decisions.  Not all rules of thumb make sense, particularly when it comes to describing investment assets, often labelling them as either growth or income.

Why is it that property investments (in this case we are meaning property securities or listed property trusts) which produce around 7% income plus or minus some growth, is described as a growth asset, whilst cash when interest rates were higher a few years ago produced a similar income level is described as an income asset? Doesn’t this tell us that there is something odd about the growth/income asset concept! 

The real problems really start when the ideas are put into practice.  For example research houses group together diversified funds on the basis of income/growth asset splits.  This is nonsense, as the assumption behind that assumes that all growth assets are of similar risk, as are all income assets! On this basis listed property trusts would carry similar risk to international shares (as they are both growth assets) and cash would be as risky as emerging market debt!

Is this really a problem? Have you ever wondered why fund managers’ balanced funds have so little property? One reason is because of the classifications by the research houses.  If a manager had a diversified fund with 30% shares and 30% property, the researchers would classify it as a growth fund and put it into a growth peer group.  Another fund may have 52% shares and 8% property and the performance of the two would be compared.  But the second fund has a significantly higher investment risk, so hopefully it would provide higher returns. 

Unfortunately, rules of thumb are often used when it comes to asset allocation and the growth/income split is used as a constraint in the portfolio construction process.  The design of a portfolio should be driven by the requirements of the investor.  How long will they need the money? How much can they save? How much do they need to spend? When do they need the money? Do they like to see regular income? And then, how do the different asset types help them meet those needs? None of this seems to have much at all to do with an arbitrary asset split based on what can be a nonsensical classification regime. It all comes down to designing portfolios on a needs basis, something that advisers in boutique financial planning practices have been doing for years.

A large portion of the investment industry uses the arbitrary asset split to provide Masterfund or model portfolio solutions to their clients’ investment needs.  They can set up for example a balanced portfolio with 50% growth and 50% income investments.  Another firm may have its balanced portfolio with 75% growth and 25% income investments.  Does it surprise you to learn that different research houses have completely different definitions of “Balanced”? Yet there is likely to be a massive difference in investment risk between the two portfolios.  Hopefully both you and your adviser know how much risk you are taking for your expected level of return.  If you don’t, you could have a real issue in the event of a market downturn.

Disclosure:As required under the Securities Markets Act 1988 and the Securities Markets (Investment Advisers and Brokers) Regulations 2007, aPascoe Barton disclosure statement is available on request free of charge, by contacting Pascoe Barton Limited on (07) 306 0080 or from www.pascoebarton.co.nz