The importance of asset allocation
Asset allocation. Perhaps the most important decision any investor can take and yet, mention that to most retail investors and you’re likely to get the blank look of boredom. Retail investors, particularly in Asia, care less about having a balanced well thought out allocation, focusing rather on the next ‘hot’ trade (which often turns out a bit damp).
In his recent book, ‘Money, master the game’, in addition to highlighting a few ways for investing more prudently, Tony Robbins highlights the benefits of asset allocation. Indeed, he notes that it is the most important investment decision one can make and has the most significant impact on returns. While Robbins makes a song and dance about interviewing Ray Dalio of Bridgewater (the world’s largest hedge fund) and getting his ‘secret sauce’, Dalio’s team has been publishing white papers on the subject for some time.
Why is it so important? Asset price performance varies year by year. Some years, bonds will do great relative to equities, with performance often reversing in subsequent years. Hence being allocated to various asset classes which offer the greatest volatility to the underlying economic factors (growth and inflation) and being disciplined about re-weighting the portfolio will allow the investor to benefit from these moves. The key here is being disciplined in rebalancing the portfolio.
While a disciplined approach is key to a successful allocation process, most retail investors let emotions get in the way, which usually results in holding an increasing allocation of the outperforming asset too long and suffering the eventual sell off, or cutting allocation to an under performing asset just as it starts to bottom
So what are the core assets to have exposure to? Cash, equities, bonds and real estate are the most widely held, but there are others such as alternatives (private equity, hedge funds etc), art and commodities. Indeed, anything that has an investible value.
Historically, the best risk adjusted returns are generated when one takes exposure to those asset classes that are not correlated and which also offer the highest returns in certain environments. For example:
- Government Bonds, particularly those with long duration, historically have done well in periods of slowing growth and declining inflation. They are negatively correlated to equities over the long run.
- Equities do best with rising growth and flat inflation.
- Gold offers strong performance during periods of expected higher inflation or hyperinflation, or coming out of periods of deflation and/or currency debasement (during the tail-end of the great depression).
- Real Estate does well during periods of improving growth and low rates/yields.
While there are many other asset classes to invest in, the bulk of these are correlated to equities. High yield corporate bonds, for example, are closely correlated and don’t therefore offer much benefit in terms of diversification.
So what allocation should investors implement? This is a personal decision and depends on a number of variables including age, risk profile etc. While a 60/40 allocation, with 60% in equities and 40% in bonds is considered by many a relatively balanced portfolio, I would advocate that it is not suitable for most retail investors.
Equities can be extremely volatile, suffer from significant sell-offs and most retail investors tend to be buyers at the top and sellers at market bottoms. While a disciplined process can mitigate this, emotions will most likely get in the way.
A typical 60/40 allocation (60% US equities and 40% 10yr US Gov bonds, annually rebalanced) since 1972 would have generated a 10% CAGR. However, with a standard deviation of just over 11% and a worst drawdown of 15%, such a portfolio can hardly be described as sitting on the efficient frontier.
Increasing exposure to high yield corporate debt at the expense of government bonds, as many retail investors do, would have made the numbers even worse. Backtesting with a 20% allocation to high yield, the standard deviation increases even further (to over 12%) whilst the largest drawdown increases to over 22%. This is due to the correlation that high yield has with equities. and investors have to sit on a roller coaster ride, whilst enjoying only sub-par returns.
In Robbins’s book, Dalio highlights the utility of a greater allocation to long and intermediate bonds, advocating only around 30% in stocks, 40% in long government bonds, 15% in intermediate notes and 15% in commodities and gold.
Such an allocation would have generated a return of just over 9% CAGR since 1972. While lower than the 60/40 split, the largest drawdown was only around 3%. Similarly, the standard deviation of the portfolio was low at less than 8% making it a very consistent performer and likely more suitable for the typical (nervous) retail investor who finds it difficult to manage through severe periods of drawdown.
For those wanting a little more juice in their portfolio, running a simple backtesting tool would indicate that adding exposure to real estate and small capitalisation stocks adds to performance, at least if history is any guide.
For example, an allocation of 30% to equity (with 15% of this in small cap value), 15% in Real estate, 40% in long dated US Treasury bonds and 15% in gold and commodities, would have generated an 11% CAGR, since 1972. The standard deviation remains relatively low at around 9% and a worst drawdown of around 9%. A far better result, with a much higher Sharpe ratio.
The point being made here is that investors can generate very consistent returns with very little risk, by having a well diversified portfolio and with only around 30% allocation to equities. I would imagine many retail investors, even those close to retirement age, have significantly more than this in terms of allocation (excluding their primary real estate exposure).
I deliberately exclude alternatives such as hedge funds due to lack of historical data but if included, an allocation of around 15% to this category would probably be reasonable. This would typically be at the cost of equity exposure, but this depends on the correlation of the HF strategy to the various asset classes.
In terms of adjusting portfolio allocation for the current market, the decision in my view is not an easy one – after a number of years of low rates and quantitative easing, most asset classes are generally expensive:
- Government bond yields have fallen across the developed world and DM bonds have generally had a terrific bull market for the last 30 yrs. 10yr yields across the periphery of Europe are still only around 2% while in Switzerland they are negative, meaning you pay to invest in these securities. The yield for 10yr Japanese government debt is <50bps, for a country whose debt/GDP exceeds 200%!
- Cash generates no yield whatsoever and large depositors need to pay to hold Euro deposits.
- Equities are also generally expensive relative to history. While the argument can be made that low rates and inflation should induce higher equity valuations, the S&P500 is now trading at around 26x (on a PE10 basis) which looks rich, particularly when one considers that margins are close to all time highs. Valuations in Europe look relatively more attractive and, with the ECB now undertaking QE, may be well supported for the next few quarters. Greece and the rest of the periphery, however, still pose a significant risk.
In terms of the key economic factors, economic growth and inflation, both seem pretty weak.
Not an easy market to make money in.
We all need to come up with our own expectation of the future and adjust our tactical (short term) allocations accordingly. To determine the most appropriate fit with ones expectation of the future, one can backtest a portfolio against various past economic environments. For example, if one expects economic growth to pick up and low inflation to be maintained, then increasingly the allocation to equities would make sense. Similarly, if one expects deflation pressures to pick up then a greater allocation to long bonds would be suitable.
My personal expectation over the next few quarters is for the USD to continue strengthening and for deflationary pressures to increase, as China slows and potentially devalues its currency to aid exports. At the same time though, investing an increased allocation to long bonds that only yield around 3% (although US government debt looks the most attractive relative to the rest of DM) carries its own risks.
While holding cash on the longer term is guaranteed to affect returns, the impact is not as severe as one may initially think. Indeed, if we adjust the allocations to 20% equity, 15% REITS, 30% Long Bond, 15% gold and commodities and 20% in cash, the results for the period 1972 to 2014 with annual rebalancing are actually fairly decent generating a mid 9% CAGR, with a standard deviation of 7% and a worst drawdown of less than 8%. Not bad for a portfolio that gives you plenty of dry powder, should we see better valuations in the next 12 months or so.
In conclusion, the point of this note is not to advocate a certain allocation over another. That depends on you, your outlook and personal situation. Rather it is intended to highlight the benefits of holding a diversified portfolio, of ideally non-correlated assets, and a disciplined process of rebalancing.