A sharp fall in equity markets over the past couple of months have brought back the importance of asset allocation in focus. The market fall was broad-based. It didn’t really matter which fund or stock you invested in. Almost everything fell.
What mattered was how much of your money was in equities.
Portfolio 1: 80% of your portfolio in the best-performing equity fund.
Portfolio 2: 40% of your portfolio in the average performing equity fund (say, a large-cap index fund)
Which portfolio do you think will do better if the markets fall by 40%?
Clearly, the second one. Because the lesser money is in equities.
What is Asset Allocation and How it helps?
Different asset classes (equity, debt, gold, real estate, commodities) behave differently under various market and economic conditions. And that’s where a prudent asset allocation strategy helps you. Adding assets with low correlation to your portfolio (diversification) can reduce the overall portfolio volatility, reduces the drawdowns (fall in portfolio) and help you stay the course.
If you have divided your portfolio among various asset classes, then it is possible that when one of the assets (say equity) is underperforming, the other (say gold or debt) may be doing very well.
Let’s say your portfolio is 100% equity and the markets fall 40%, your portfolio will also be down by 40%. After the fall, your portfolio will need to rise by 66.66% just to break even.
On the other hand, if your portfolio was 50% equity and 50% debt, your equity portfolio will be down 40%, but your overall portfolio will be down only 20% (assume 0% return for debt investments during the period). After the fall, your portfolio needs to rise by 25% to break even. Lower portfolio drawdowns increase the odds of your investment success.
One of the keys to investment success is to lose less. And diversification (asset allocation) will help you do that. Moreover, regular portfolio rebalancing can help you stay within the target asset allocation and perhaps provide you additional return too.
What is the Best Asset Allocation for you?
I don’t know.
Sitting today, you can go and check the best asset allocation from 1990 to 2020, but there is no guarantee that what worked in the previous 30 years will work in the next 30 years too (efficient frontier analysis). Therefore, this information is not really actionable (even though there is a lot to learn from this info).
The best asset allocation for a long-term portfolio from 2020 to 2050 (for a given level of risk) will be known only in 2050 i.e. you can find the best asset allocation for a period only in hindsight.
It is possible that a 100% allocation to bitcoins may outperform any portfolio over the next 30 years. However, will you be comfortable holding such a portfolio?
Because we can’t be sure. And a single (high risk) asset portfolio will be super volatile.
Acknowledge what we don’t know.
Believe it or not, when it comes to asset allocation, simple heuristics can do a decent job.
Let’s assume there are only two asset classes, equity and debt.
For short term goals, you must invest in a debt-heavy portfolio.
For long term goals, you must invest in an equity-heavy portfolio (I ignore risk profile for now).
“Heavy” is subjective.
In my opinion, “Debt-heavy” portfolios should be almost 100% debt. On the other hand, having 100% in equities, for long term portfolios, is not a good choice. Even 90% or 80% or 70% equity is too “Heavy”. Such aggressive portfolios can witness very sharp drawdowns (fall in portfolio value).
And it is not easy to see sharp drawdowns in your portfolio. It can compromise investment discipline.
Your destination is important. However, the journey matters too. If the journey is too painful, you can leave the ship before reaching the destination. None of us is 100% rational. We are emotional beings. Even though we might be very optimistic about equity returns, sharp losses worry us.
These sharp falls can make your doubt your investment strategy. By the way, you might indeed have a very bad investment strategy. Remember, nothing is guaranteed with equity investments. In fact, the equity has commanded a return premium because you are not guaranteed good returns.
Thus, for most investors, it is important that you work with an asset allocation approach and rebalance your portfolio at regular intervals.
Coming back to the choice of asset allocation, assuming equity and debt are the only two asset classes, a simple 50:50 or 60:40 equity: debt allocation will be fine for aggressive investors for long term portfolios. If you are a conservative investor or your risk-taking ability is low, you can reduce allocation to equities. While constructing the equity portfolio, do not limit yourself to just domestic equities. Adding international equity can add value.
Be honest about your risk appetite. During good times, everybody claims (or wants) to be an aggressive investor. It is during bad times that the true risk profile of an investor can be assessed. Don’t worry if you got it wrong the first time. Learn from these losses and adjust your asset allocation.
If you have a low risk-appetite, then a high allocation to equities won’t work for you. You just won’t stay the course. You can work with a Registered Investment Adviser to help you become more comfortable with risky assets. Alternatively, you need to rethink your approach to investments. Don’t unnecessarily follow the herd. Staying the course is extremely important.
Additionally, any long term goal will eventually become a short term goal. Make adjustments accordingly.
Your choice of asset allocation is NOT about being perfectly right. It is about being less wrong.
The above point is extremely important in today’s context (April 2020). After the recent correction, there are many voices (with a massive conflict of interest) impressing upon investors (like you and me) that this is a very good time to buy. May well be but we don’t know for sure. At least a few well regarded investors have implied that you will be missing out on something if you don’t buy stocks now. Creating a fear of missing out (FOMO). With such statements, I have a problem.
Such statements can mislead investors into believing that this is a once-in-a-lifetime opportunity and they may position their portfolio very aggressively towards equities. This may well be true but where is the buffer. What if the pundits are wrong and there is bigger correction about to happen? Higher risk does not always mean higher rewards.
This is where sticking to the asset allocation can help you. It is possible that you may miss some of the upside by sticking to asset allocation. At the same time, this approach may prevent your portfolio from getting destroyed. In the present context, you might divert some money to equities provided your asset allocation permits.
You are more likely to create long term wealth by following a process (than going for long shot investments). The asset allocation approach and regular rebalancing is one such process.
The expectation from asset allocation (and regular rebalancing) should not be to maximize returns and to reach your destination (financial goal) with ample to spare. The expectation should be to make sure that you reach your destination comfortably.
If you are keen to read more about the right Asset Allocation for your portfolio, do read “The Intelligent Asset Allocator” by William J. Bernstein. There is no better book on Asset Allocation.