The Art Of Asset Allocation

Foreword from ShareInvestor

This article “The Art Of Asset Allocation” by Cai HaoXiang was first published in The Business Times on 29 Jun 2015 and is reproduced in this blog in its entirety.

A portfolio must provide for a scenario in which it does not suffer massive losses in the high-risk portions should a financial market crash soon after the money is put to work.

THERE was a popular Japanese video game in the 1990s called Pokemon with the slogan: “Gotta catch ’em all!”. In the game, you collect monsters and train them to fight other monsters. Like that game, investors in financial markets also sometimes want to “catch them all”.

Consider this scenario: Today, you come across a stock you think is attractive. You put it on your watchlist. You might even buy some for your portfolio.

Months later, you may have forgotten about that first stock, having noticed another which you consider more interesting. The original stock may have appreciated slightly and you think it too expensive to buy more.

Meanwhile, the new stock might not be as attractively valued. Yet there’s the novelty factor of learning about a stock for the first time which makes it somehow more enticing. So you buy a little bit of the new stock.

Eventually, you might end up with well over 30 stocks in your portfolio. They will all have been attractive to you at some point in the past, but now you hold too many to track.

Carefully analysing each stock over again to decide whether it should stay or go is too stressful and time-consuming a process.

Thus those stocks continue languishing in your portfolio, accumulating dust and not too many dividends. Some turn out to be complete duds.

You could have sold them a long time ago if you had made the effort to cut out stocks that do not fit your investment strategy.

But you didn’t, and now you are regretting it.

I’ve met investors with similar stories. All fell prey to the overwhelming number of choices available in the stock market: hey, this looks good. Hey, that looks good, too!

Investors should strive to avoid this Pokemon syndrome by taking a long, hard look at their stocks every year to decide whether these are the stocks they would hold. It’s a process very akin to spring cleaning – out with the old first before adding the new.

One question that will help is: If you had to start all over again with the same amount of money, what stocks would you choose?

Mental Accounting

Another interesting way to help people manage their personal portfolios revolves around a psychological tendency known as mental accounting.

We see this when some people like to keep a long-term portfolio and a trading portfolio, thinking that the two are different – when they effectively only have one pool of money to invest.

Sometimes, we end up with excessive risks being taken in the “trading” portfolio because one thinks it’s “play money”. On the contrary, if one thinks rationally, allowing such a situation to develop does not optimally allocate one’s assets even though some psychological impulses might be satisfied.

We also see mental accounting in the “bucket allocation” or “pyramid” method that financial advisers like to talk about.

This method can be summed up thus: the base of the pyramid, or the first “bucket”, comprises low-risk investments to meet one’s basic needs in life, such as food and transport.

These needs can be met by government bonds or the government’s lifelong annuity scheme, CPF Life.

People, however, have desires such as wanting to send their children to a university overseas, wanting to upgrade to a bigger house, or wanting to take a retirement holiday around the world.

These wants require an eventually higher level of assets that might only be achieved by taking more risk with one’s initial assets.

To meet the higher requirements, money will have to be set aside in stocks, regarded as a riskier asset class.

Over a sufficiently long period of time, stocks can return, say, 7-8 per cent a year. This leads to one’s initial investment doubling within 10 years.

However, one is likely to meet a down cycle during those 10 years. In a bad year, assets placed in equities can easily lose 20-30 per cent of their value.

The theory goes that the money placed in these risky buckets at the top of the pyramid can then be used to satisfy these expensive desires.

Over time, as these buckets fulfil their returns target, money is shifted to lower-risk buckets to meet ongoing basic needs.

The bucket allocation method is not wrong. Mental accounting might have a psychological bias, but it is a useful construct from which to view the world and plan a portfolio.

For example, segregating one’s portfolio thus can encourage a risk-averse person, who should actually be taking on more risk to meet his retirement needs, to do so in the upper buckets or levels of the pyramid.

However, we are essentially creating artificial distinctions without considering the relationships between all these mental accounts. As a result, we may end up taking too little risk and too much risk at the same time. This can happen if we are too conservative for our first bucket, investing in assets with minimal returns. We might separately take on too much risk for the upper buckets, say by investing in small-cap stocks.

For example, we might misallocate the right amount to the “safe” first bucket because we misjudged the likelihood of a downturn.

If a financial market crash hits soon after we put our money to work, we suffer massive losses to the high-risk portions of our portfolio.

The assets allocated there never get the chance to compound to the level where they can meet our longer-term desires, or even where they can spill over to meet our shorter-term ones.

In the meantime, our safe bucket might run out of money because we wanted it to be absolutely safe, and those assets did not really grow fast enough.

Naïve Diversification

Is there a better way to allocate one’s assets? Modern portfolio theory, developed in the 1950s by others including American economist Harry Markowitz, claims to have a solution.

The theory assumes every investor will have a unique level of risk that he or she is willing to tolerate. Modern portfolio theory aims to calculate the ideal portfolio for an investor that gives the best return for his or her preferred level of risk. It takes into account the effects of diversification, where the combination of two or more assets can lower their risk.

Commercially available programmes can calculate the proportion in the portfolio each asset should take up: a process known as mean-variance optimisation.

One problem with this is that the calculation is highly sensitive to changes in the inputs, which are expected asset returns.

If the ideal portfolio allocation keeps changing dramatically all the time, this method cannot be practically applied to manage an actual portfolio.

Over the years, people have made some improvements to the mean-variance optimisation model, or suggested alternatives. However, evidence is mixed that complex models work better than what is known as naive diversification.

Otherwise known as the “1/n” rule, naive diversification refers to simply allocating the same amount to each risky asset.

If I had S$100,000 and 10 stocks, for example, I would buy S$10,000 worth of each stock.

Or I would divide my assets into one-third stocks, one-third bonds, and one-third real estate.

The level of safe but low-return bonds that one needs is subject to debate, depending on your age and your job.

Traditionally, people have practised what is known as life-cycle investing. Fund managers pitch these funds as target-date funds.

The idea is to take less and less risk as you get older, and tilt your asset allocation towards bonds.

Yet in this world of artificially low rates, it is not the smartest idea for retirees who need a higher return to keep their money in safe but expensive bonds yielding nothing.

As some have put it: You think you’re getting a risk-free return, but you’re actually getting return-free risks.

The way a stockbroker should invest is also different from the way a teacher or doctor should invest.

A stockbroker’s income will fluctuate with the market. It makes sense for him to have a higher allocation to bonds in his personal portfolio to smooth out these fluctuations, given the boom and bust nature of his job.

A teacher or doctor, meanwhile, will always have a regular paycheque. They have a safety cushion from which to take higher risks with their personal portfolios.

By the way, Professor Markowitz, who won the 1990 Nobel Prize in economic sciences for his portfolio theories, is still teaching in California.

How does the great man himself invest?

There’s a story about him figuring out how to allocate the money in his retirement account, recounted by personal finance columnist Jason Zweig.

Prof Markowitz told Mr Zweig: “I should have computed the historical co-variances of the asset classes and drawn an efficient frontier.

“Instead, I visualised my grief if the stock market went way up and I wasn’t in it – or if it went way down and I was completely in it.

“So I split my contributions 50/50 between stocks and bonds.”

Sometimes, the simplest solution is the most elegant.