Financial history has been a witness to an investment yielding huge gains for individuals who bought & held it for a long-generation-long period as well as how these very assets have had a deep & painful drawdown*. It is often inferred from recent history – last 40 years of 200 plus financial years – that it is profitable to wait out the underperformance of stock market. Inferences are similarly drawn for other asset classes as well, on basis of what has transpired during last few decades.
(*Drawdown is % by which market value of asset drops from its previous high.)
However, a more holistic assessment of what has transpired during these 200 years, indicates that epochal changes have taken place in the past & will do so again in future. The inferences / assumptions of how investments pan out over a period of time, need to be taken with a pinch of salt given the following data points:
- Stocks underperformed Bonds from 1929 to 1949 in USA. The investors lost 80% from top during this period & that would have needed 300% gain just to get even i.e., compounding of 6.41% (average US equity return) for 26 years. A 50% drawdown would need 11 years at same rate to break even. There have been 3 periods in last 75 years of US stock market when S&P 500 index took more than 10 years to go past its previous high point.
- Bonds too have had deep drawdowns in the past – 60% in US & UK & 80% in France, Italy, Japan & Germany. Hyperinflation has destroyed value in other countries as well at different times in history.
The above exemplifies huge risk of investing in one security, country or asset class. An asset class (including Equity) can possibly go on underperforming other asset classes for a very long time & an investor may not have sufficient time to recover from the drawdown. Financial planning needs take such risks on board to avoid disastrous consequences.
Optimizing Risk-Reward ratio
Risk is the measure of uncertainty of achieving return as per investor expectation. It can assume different guises i.e.,
- fluctuation in value of investment (due to market movements & changes in interest rate / exchange rate),
- permanent loss of capital &
- inflation (loss of purchasing power).
Risk-Return trade-off means that invested money can render higher profits only if the investor accepts a higher possibility of loss. While there is no perfect measure that encapsulates all risks of investing, volatility catches its essence well. Each asset class** has a certain risk profile & return expectation dynamic. Cash & fixed income provide known income streams. The low variation of returns (standard deviation) makes it a lower risk investment than property & shares, where a higher potential for return is accompanied by far more variation in the income streams & capital value over time.
Optimizing the risk-reward ratio of an investment portfolio means that returns are maximized by diversifying investment across a range of asset classes, regions, sectors & securities, while reducing overall risk of the portfolio. The objective is smoother returns over the long-term & a surer glide path to financial goals.
It is a grouping of investments with exhibit similar risk-return dynamics & cash flows. Each such group performs differently in any given market environment thereby reflecting little or negative correlation with outcome of other classes. Equities, Fixed Income, Cash & Cash equivalents, Real Estate, Commodities & Currencies are the various asset classes to choose from at time of investment.
What is Asset Allocation?
Asset Allocation is the strategy of – ‘optimizing the risk-reward ratio’ of the portfolio – by dividing the investments in a definite ratio – across various asset classes. The objective is to help navigate the uncertainty of the investment process & maximize risk-adjusted returns of portfolio in order to achieve financial goals with fair degree of certainty.
Impact of Asset Allocation on Portfolio Returns
Asset Allocation ensures that one takes the right amount of risk for the desired rate of return needed to achieve financial objectives. Risk – too much or too little – can derail a financial plan.
- Variability of ‘returns across time’ – 90% of the movement of one’s portfolio from quarter to quarter is due to market movement of the asset classes in which the portfolio is invested. Bullish or bearish sentiments prevailing in the market for asset classes has an overwhelming influence on returns of total portfolio.
- Variation of returns between Mutual funds / Pension funds – 40% of it can be attributed to Asset Allocation Policy followed by the fund, while the rest 60% is explained by security selection, timing, & fee differences of these funds.
The impact of asset allocation on ‘portfolio returns’ depends on the investing style.
- Long-term, Passive investor – Asset Allocation has a significant influence on ‘buy & hold’ investments. Given that it is mostly passive investment behavior that guides corpus accumulation for retirement, asset allocation decision has a ‘make or break’ effect on retiree.
- Short-term / Trading investor – Frequent trading in individual securities &/or practicing market timing strategy hugely lessens the impact of asset allocation of portfolio on returns.
How to allocate?
An investment portfolio should be constructed in a way that it best reflects the investor’s
- Return Expectation – that meets short-term, medium-term & long-term goals,
- Time horizon of investments,
- Assets & liabilities,
- Risk Capacity – financial ability to bear volatility &/or loss,
- Risk Tolerance – personality trait of how one reacts to adverse events &
- Risk Appetite – combining capacity & tolerance to decide degree of risk that may be taken.
Why is Asset Allocation so crucial?
Asset Allocation policy strives for optimal risk for desired returns because mismanaged risk creates havoc with financial planning of the investor. Too much volatility can be as counter-productive to the cause as is the destruction of purchasing power on account of volatility-avoidance. Inflation is an investment risk. It destroys purchasing power & also influences setting of interest rates in the economy, the effect of which transmits through Debt, Equity, Real Estate, Gold, Commodity & Currency markets in varying ways. Thus, arises the need for diversifying investments among asset classes with little or negative correlation, to not only mitigate the loss of purchasing power by earning real return but also lessen the effect of drawdown of risky assets on total portfolio.
Given the historical performance of risky assets, it is easy in the hindsight to feel an investor can wait out the underperformance of an asset class but
- it is a behavioral challenge for an investor when it is actually happening. 5 years is a short time in an investment cycle but can feel a lifetime for an individual.
- An investor is either looking at a peak or a deep drawdown & attitude to risk changes with market cycles, driven by greed & fear. Bull market pushes investors to more buying & bear markets towards scaling back on investments. Recency bias makes sure of that.
- The largest drawdown is likely to be in future as the corpus generally grows over time. A deep downturn will happen on a higher base & a higher damage as a result.
- Price paid for risky asset is extremely important. Last 15 years have yielded lesser post-inflation equity returns than average real return of last 30 years because valuation (PE ratio) at which equity is available matters a great deal. The high starting valuations set the stage for poor returns in the following period. Once PE goes beyond a certain level, forecasted median returns become negative for following 10 years.
- Gold has been a hedge against political, social uncertainty & inflation but is not a productive asset. The returns from this asset need to be conservatively assumed.
Asset Allocation brings a certain discipline to the investment process because investment decisions get driven by the policy of asset makeup of portfolio & not by market driven emotions. Portfolio should be rebalanced whenever market conditions push the weightage beyond an acceptable variation. Such discipline of investment process not only reduces portfolio volatility but also produces superior risk adjusted returns.
ASSET ALLOCATION STRATEGIES
Strategic Asset Allocation
It targets a fixed proportional combination of assets based on expected rates of return for each asset class. It is akin to a buy-and-hold strategy, with diversification to manage risk & improve returns. For example, if stocks have historically returned 12% p.a. & bonds have returned 6% p.a., a mix of 70% stocks & 30% bonds would be expected to return 10.2% per year.
Tactical Asset Allocation
It is a moderately active strategy wherein short-term, tactical deviations may be made to capitalize on exceptional investment opportunities. The market-timing seeks to participate in more favorable economic conditions for an asset class as compared to others. The overall strategic asset mix is returned to when desired short-term profits are achieved. The asset mix of portfolio should reflect the goals at any point in time.
Dynamic Asset Allocation
In this active asset allocation strategy, the mix of assets is constantly adjusted to reflect the changes in the investment environment. The changes made to asset allocation may be on the basis of portfolio manager’s judgment or a pre-determined investment framework. This strategy is polar opposite of strategic asset allocation.
Integrated Asset Allocation
While all the strategies mentioned above focus on expectations of future market returns, investor’s risk tolerance is not built into the framework. Integrated asset allocation strategy accounts include risk tolerance in deciding the asset mix whenever changes in the market environment demand an adjustment.
Risk Parity Allocation
Ray Dalio advocates concept of ‘Risk Parity’ that constructs a portfolio based on risk of the asset class. Most portfolios have a very strong bias to do well in good times & bad in bad times. A 60/40 stock/bond portfolio does not have ‘60% of overall risk’ weighted to stocks, rather 90% because equity is 3 times more volatile than bonds thereby dominating overall total volatility. He observes that every investment has an ideal environment in which it flourishes i.e., there is a season for each kind of investment.
There are 4 types of investment environment created by how growth & inflation measure up against market expectation. The type of environment that gets created by confluence of these economic forces, provides the conditions for certain asset classes to flourish & the rest of asset classes to languish. How growth & inflation measure up against market expectation, creates an economic environment that provides perfect conditions for certain asset classes to give better returns –
- Higher Inflation – Commodities, Gold, Inflation linked Bonds
- Lesser Inflation – Stocks, Treasury Bonds
- More Growth – Stocks, Corporate Bond, Commodities, Gold
- Less Growth – Treasury Bonds, Inflation linked Bonds
He therefore advocates to have 25% of risk in each of these four categories – not 25% of wealth in each category. That is because nobody really knows which of 4 seasons will come next. With this approach, each season is covered all the time, so you’re always protected.