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Rama Krishna Vadlamudi, HYDERABAD
14 October 2012
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Each one of us wants to earn better
returns from our investments, so that we can lead a life the way we want to. Asset
allocation plays a pivotal role in investment management. Why so? A lot of
research has gone into asset allocation process for several decades. Asset
allocation concerns with choosing an asset mix and putting your funds into
various asset classes – such as equities, bonds, commodities and real estate.
A home garden blooms with a variety
of plants, creepers, trees and waterholes enticing several residents, birds and
creatures. One cannot imagine a forest without carnivores because without them,
herbivores would overrun the Earth. Without herbivores, the world would be
awash with plants and trees. So, Nature needs to have some kind of balance
among its varied species – known as biological diversity or biodiversity.
In a similar way (if not exactly),
investment management requires us to decide an appropriate asset allocation
which balances out the risks and rewards involved in various asset classes. Each
asset class has its own salient features. Some asset classes provide easy
liquidity, while some others offer higher returns. Before deciding on the asset
allocation, the following aspects need to be examined thoroughly:
1. Risk
tolerance – the ability and willingness to take risk
2. Expected
return – the expected return from the proposed investment
3. Liquidity
needs – any requirement for cash in the near term
4. Tax
concerns – tax concessions, if any or the investor’s tax bracket
5. Personal
situation – e.g., an investor has no time or expertise
6. Time
horizon – investment’s time period like, one year, 5 years or more
What is risk? Risk, the most
misunderstood term in the financial world, means different things to different
people. Risk is the probability of losing one’s money. An investor needs to
have some knowledge of finance before putting her hard earned money into
various baskets of investments. Otherwise, it would not be called as investing,
but gambling.
The asset class returns are highly
volatile. Equities and bonds may give excellent returns in a year, while commodities
give dismal returns in that period. In another period, commodities may outshine
other asset classes.
Nobel-laureate Harry Markowitz’s
Modern Portfolio Theory revolutionized the concept of portfolio diversification
since mid-1970s, though it received severe criticism of late.
Some investment gurus, like, Warrant
Buffett, detest diversification whereas another guru John Templeton praised its
virtues. Ultimately, investors have to decide on the asset allocation suitable
for their needs.
But diversification has its pitfalls.
Having too many baskets may harm your beloved capital. Some individual
investors invest in 100 or 150 stocks and many other investments – this is
mindless over-diversification. In the process, they lose track of their
investments.
As we have seen in the global
financial crisis 2008 when most of the assets classes plunged, asset allocation
and diversification may not save the blushes for investors. However, the
time-tested principles of asset allocation and diversification cannot be wished
away and they are suitable for conservative investors.
The analysis follows – detailing the
features and historical returns of asset classes, importance of asset
allocation, diversification, Guru speak on diversification, portfolio
rebalancing & five golden rules for investors.
The broad asset classes are equities
or shares, bonds or fixed income, cash & cash equivalents, real estate and
alternative investments.
Cash equivalents are investments in
liquid instruments, for example, US Treasury bills. Alternative investments can
be further classified as commodities (like gold, silver, crude oil, copper,
coffee, and soyabean), currencies, private equity and hedge funds’ derivative
strategies.
Shares and bonds can be subdivided
into assets in emerging markets, developed markets or frontier markets. In
fact, one can subdivide these broad asset classes into several kinds of narrow
asset classes – for example, large cap stocks, mid cap stocks, growth or value
stocks, non-US bonds or treasury-inflation protection securities (TIPS).
What are the Features
of Asset Classes?
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Different asset classes have
different features. Investment in real estate is highly illiquid in general;
whereas investment in large-cap equity shares is highly liquid – in the sense
that investments can be converted into cash easily and immediately.
This table gives a broad overview of liquidity, risk and
return parameters of some asset classes:
Asset
Class
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Liquidity
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Short-term
return
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Long-term
return
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Short-term
risk
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Long-term
risk
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Large
cap equity shares
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High
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Uncertain
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High
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High
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Low to
Moderate
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Mid
cap equity shares
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Moderate
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Uncertain
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High
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Very High
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Moderate
to High
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Real
estate
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Low
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Uncertain
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Moderate
to High
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Low to Moderate
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Moderate
to High
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Commodities
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High
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Uncertain
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Moderate
to High
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Moderate
to High
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Low to
Moderate
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Govt.
Bonds (long term)
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Low to
Moderate
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Low
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Moderate
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Low
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Low to
Moderate
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Govt.
Bonds (short term)
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High
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Low to
Moderate
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Low to Moderate
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Low
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Low
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Cash
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Very High
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Low
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Low
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Low
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Low
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Note:
The above table is only for illustrative purposes
1. Short-term returns on equities, real
estate and commodities are uncertain – but the chances of getting attractive
and superior returns from them in the long-term is high
2. From a risk point of view, the risk
of losing one’s money in the short-term is higher in case of equities and
commodities
3. Cash entails low risk and return, but
offers higher liquidity
4. Government bonds bear no default
risk, but have interest rate risk – the latter risk is higher for long-term
bonds
5. As we have experienced in the past
few years, even government/sovereign bonds may suffer huge risk – for example,
as in Greece, Spain, and Portugal, following the ongoing
euro crisis
Historical Returns of
Asset Classes
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Asset prices go up and down always.
The prices of asset classes do not move in tandem. The return from an asset
class may be positive in a year but the return from another asset class may be
negative in the same period. The following chart
depicts 5-year average (simple) returns of four asset classes – US equities,
commodities, US fixed income and US real estate depicting variability of
returns over 20 years from 1992 to 2011:
1. Asset Class Returns –
Four 5-year average periods 1992-96 to 2007-11
Notes:
Data is collated from Morgan Stanley and Invesco. US Equities – S&P 500
equity index represents top 500 companies in the US, includes dividends and
distributions. Commodities are represented by S&P GSCI index. Barclays
Capital Aggregate US Bond Index represents US fixed income containing
investment-grade bonds. And US Real Estate is represented by FTSE NAREIT All
Equity REITs Index.
1. As the above chart depicts, the
returns of various asset classes are highly volatile – for example, S&P 500
equity index provided average yearly return of 16% during 1992-1996 whereas it
provided only 2.4% during 2007-2011
2. During 2002-06, US equities (S&P 500) and fixed
income offered only 7.6% & 5.1% respectively; but commodities (S&P
GSCI) and real estate provided spectacular returns of 16.1% & 24%
respectively
3. Only returns from US fixed income
appear a little stable during the four 5-year periods shown above
4. One intuition from the above chart is
that no single asset class provides stable returns and all the asset classes
undergo variability of returns and as such allocation among uncorrelated asset
classes provides safety.
The above Chart 1 can be
shown differently by putting the returns as per asset class returns to depict
the volatility of a particular asset class graphically. In chart 2, the blue
line for US real estate returns appear to be more volatile as compared to US
fixed income shown as yellow line.
2. Four 5-year average
periods 1992-96 to 2007-11 by Asset Class Returns
What is Asset
Allocation?
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Simply put, asset allocation is
distribution of investible surplus money into various asset classes, such as
equities, commodities, bonds, or real estate. The purpose of asset allocation
is to achieve an investor’s objectives from investments and to moderate
investment risks.
Let us assume an individual investor
has $ 1,000,000 of available funds to invest in some asset classes. She has to
make a decision regarding the asset mix – how much amount to put in equities,
how much in bonds or commodities or how much in other asset classes. While
deciding the asset mix, she needs to keep in mind her investment goals, her
risk appetite, time period of investments, tax concerns and her personal
situation.
Institutional investors also, more or
less, follow a similar approach though institutional investors have larger
resources, their investment universe is bigger, they have higher regulatory
hurdles, and they have both assets and liabilities to take care of more
seriously.
Asset allocation is not static, it is
a dynamic process. It is an important
part of an investor’s portfolio management process. Before deciding on the
asset allocation, the following aspects need to be examined thoroughly:
1. Risk
tolerance – the ability and willingness to take risk
2. Expected
return – the expected return from the proposed investments
3. Liquidity
needs – any requirement for cash in the near term
4. Tax
concerns – tax concessions, if any or the investor’s tax bracket
5. Personal
situation – e.g., an investor has no time or expertise
6. Time
horizon – investment’s time period like, one year, 5 years or more
There are several types of asset
allocation. Strategic asset allocation (SAA) involves specifying an investor’s long-term
return objectives, depending on investor’s ability & willingness to take
risk, market expectations and investment constraints.
Another major type of asset
allocation is tactical asset allocation, which focuses on making short-term changes
to weights of asset classes based on short-term view on market performance of
selected asset classes.
The Importance of
Asset Allocation
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In 1952, Harry Markowitz floated an
innovative theory, known as Modern Portfolio Theory (MPT) for which he received
a Nobel Prize in Economics. MPT basically demonstrates why putting all your
eggs in one basket is an unacceptable risky strategy and why investors get
benefits from diversification. The theory has been used widely across the world
for more than five decades but of late it has received wide criticism following
the global financial crisis in 2008 when all asset classes heavily suffered the
same fate of severe meltdown.
Many investors sold heavily during
the market crash of 2008 – but they did not reinvest when the markets were
extremely cheap in that period. After March 2009, the markets recovered
spectacularly and many investors could not benefit from the large upswing in
asset prices.
A few studies in the 1980s and 1990s
have shown that asset allocation explained more than 90 per cent of the
variation of returns over time for large pension funds. Another study done in
2000 found that about 40 per cent of the variation of returns across funds was
explained by asset allocation policy and the remaining 60 per cent was
explained by factors such as market timing, security selection, fees and
investment style.
Whatever be the percentage, asset
allocation still is very important for investors, who have to take into account
their return objectives in line with their own risk appetite. It would be
beneficial for long-term investors to invest across asset classes.
In my village where I was born, a
typical middle class family was following a simple asset mix plan. In the1970s
and 1980s, the family’s homemaker would buy gold ornaments and house furniture
while the husband would invest in property or land – a simple asset mix without
knowing it! Now that land and gold prices have soared, these middle class rural
people proved to be much smarter than you and me!
What is the Suitable
Asset Allocation?
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Rakesh Jhunjhunwala is a well known
equity investor from Mumbai,
India. He has
invested across a number of companies’ equity shares. He is said to be worth a few billion dollars,
if not more. He claims that he has invested 100 per cent of his money in Indian
stocks! He asserts that he does not like to invest in real estate nor in
international equities.
Obviously, his allocation is not
suitable for others. The allocation differs from person to person or institution
to institution. No emotions should be involved while choosing asset mix. Let us
take a hypothetical example.
Mike Gates from the US is a 35-year
old senior executive in a well-established pharmaceutical company. He has
received a windfall gain of $1,000,000 from stock options. His total surplus is
$1,000,000 and he has to decide about the investments to be made out of this.
His risk tolerance is above average
and expects to receive above average returns from the investment. He wants to
retire by age 60 and would like to invest the surplus for his retirement needs.
He requires a little liquidity for his lifestyle needs. It is assumed that he
has no tax concerns. He has no other constraints, like supporting a family
financially.
What kind of asset allocation would
be suitable to Mike Gates? Mike is young and the potential to earn future
income is very high. His risk tolerance and expected return are above average
and as such he can put a higher share in equities, say 65 per cent of $1,000,000
surplus. The remaining can be put in bonds, real estate and commodities. Periodic
interest from the bonds (fixed income) and salary income will take care of his
liquidity needs. The following asset allocation is suggested for Mike:
Note:
The above graph is only for illustrative purposes
Benefits of Portfolio
Diversification
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In many cases, it is beneficial to
diversify across companies and industries to mitigate risks. For most
investors, diversification is the simplest and cheapest way to risk mitigation.
Diversification is an established tenet for conservative investors and it is
especially helpful when the returns of two or more investments are perfectly
negatively correlated, resulting in substantial risk reduction. Negative
correlation expresses the inverse relationship between the returns of two
securities – which means their returns move in opposite direction.
On the contrary, in cases when
returns of two investments are perfectly positively correlated, diversification
will not provide risk reduction, only risk averaging. Positive correlation
indicates that the returns of two securities move in the same direction – that
is, they tend to go together. If the return of one security goes up, the return
of the other security also tends to increase and vice versa.
Diversification can substantially
reduce security-specific risk, but not market risk. That is why for a
well-diversified portfolio, security-specific risk is practically
insignificant.
Some sophisticated and institutional
investors go for international diversification, investing in securities in
different countries. Of course, they have to take care of political risk and
currency risk involved in such international securities.
Institutional investors broadly
consist of pension funds, sovereign wealth funds, endowments, insurance
companies, banks and other financial institutions.
Over-diversification is detrimental
to an investor’s wealth. So is under-diversification. Many investors hold 15 to
30 different mutual fund schemes. A mutual fund itself holds a number of
securities. So it does not make any sense to hold more than three or four
mutual fund schemes belong to a particular asset class. For example, it is
better to stick to holding not more than three or four equity schemes under
equity asset class.
Suppose an investor in 2012 has 40
per cent of his assets in equities, 20 per cent in bonds, 35 per cent in real
estate and 5 per cent in gold. After one year assume that the investor’s asset
mix changes as – equities 50% and bonds 10%; while real estate and gold remain
the same proportionately. So in 2013, 10% of the wealth can be sold out of
equities and the same can be ploughed back to bonds to restore the original
balance in the total portfolio. This is called portfolio rebalancing.
Several mutual funds do this type of
portfolio rebalancing through funds such as, balanced/hybrid funds, asset
allocation funds and funds of funds. Some sophisticated and knowledgeable
investors do portfolio rebalancing every year on their own.
Guru Speak on
Diversification
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Let us find what investment gurus
tell about portfolio diversification:
Benjamin
Graham: He was considered the father of value investing. He
said, “That there should be adequate though not excessive diversification. This
might mean a minimum of ten different issues and a maximum of about thirty.”
Benjamin Graham further suggested
that an individual investor should never have less than 25 per cent or more
than 75 per cent of his funds in common stocks, with a consequent inverse range
of between 75 per cent and 25 per cent in bonds. Graham suggested a 50-50
bond-stock allocation for many of the conservative investors even though this
50-50 mix looked like an oversimplified formula. Graham ignored other asset
classes – gold, real estate, etc. – saying he did not have the required
expertise in them.
Philip
A Fisher: Philip Fisher was a legendary growth-stock investor. He
was not a great believer in over-diversification. He stressed, “For individual
investors, any holding of over twenty different stocks is a sign of financial
incompetence. Ten or twelve is usually a better number. An investor should
always realize that some mistakes are going to be made and that she should have
sufficient diversification so that an occasional mistake will not prove
crippling.” However, Fisher warned that one must be alert to the danger of investing
in companies of a single industry.
John
Templeton: Philanthropist-cum-fund manager John Templeton was
renowned as one of the best investment managers in the 20th century.
He advocated diversification by company and by industry. He said, “There is
safety in numbers in stocks and bonds. No matter how careful you are, you can
neither predict nor control the future. So you must diversify.”
Warren
Buffett: The Omaha, Nebraska-based legendary investor Warren
Buffett does not believe in diversification. He says one should only invest a
lot of money in a few quality companies. “Diversification serves as a
protection against ignorance,” he avers. A major portion of his investments are
in a few companies – like, Coca-Cola, Gillette, Wells Fargo and American
Express.
David
Dreman: He suggested holding of 20 or 30 stocks across 15 or
more industries. He said that returns from individual issues will vary widely,
so it is dangerous to rely on only a few companies or industries.
Five Golden Principles
for Investors
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Following these five golden
principles will keep you ahead of the markets:
1). Margin of Safety:
The concept of margin of safety is the most important of Benjamin Graham’s
investment principles. He argued that we should never overpay for our
investments because our estimate of future cash flows of an investment could be
wrong. As such, we require some protection, cushion or margin for our errors of
estimation and judgment – so that the chances of getting satisfactory returns
are brighter.
2). Understanding the Asset:
Do your own research by spending your time on understanding the asset. For
example, before investing in a stock or equity share of a company, learn about
how the company earns its profits and revenues. Who are its competitors and how
the company is tackling the competitive pressures? What is the quality of the
management, its cash flow, profit and loss account and balance sheet? These
fundamentals will keep you in good stead before you put a price on the stock.
3). Play Your Own Game:
A fair knowledge of how financial markets operate is a necessary pre-requisite
before you plunge into the investment world. Markets consist of millions of
investors, speculators and traders. You have to play your own game to succeed
against millions of others. Never follow the crowds. Mind you there will always
be a few crooks ready to decamp with your money if you are not alert to their
machinations.
4). Know Your Risk Appetite:
Suppose you have invested $50,000 in a commodity hoping to get a return of 30
per cent in two years. Do you have the stomach to tolerate if the commodity’s price
falls by 20 per cent or 25 per cent within a year, which is very common? If you
require some cash urgently, are you prepared to sell this asset at a steep
discount to your acquisition price? These questions will help you in
understanding your own risk appetite.
5). Too Much Leverage is Dangerous:
The collapse of hedge fund Long-Term Capital Management (LTCM) brought into
focus the perils of over-leverage. LTCM, founded inter alia by two
Nobel-laureates Robert Merton and Myron Scholes, had built up huge positions to
the tune of $ 1,250 billions in financial derivatives market taking on leverage
of about 35 times of its own funds. It collapsed in 1998 following Russia’s
default causing severe turbulence in markets. An individual or institutional
investor is likely to face a similar rout if they depend on excessive debt.
In times of market crashes and crises,
correlation among asset classes is especially high as was proved during the
global financial crisis in 2008, when most of the major asset classes suffered
heavy losses and asset allocation did not provide the benefit expected of it.
This is a major limitation of asset allocation. During market meltdowns, it is
extremely difficult to deflect the downside risks.
The asset allocation process is
neither a silver bullet nor a magic wand. Even if you follow asset allocation
process meticulously, there is no guarantee that you will be able to attain
satisfactory results. Ultimately, asset allocation is vulnerable to market
gyrations. If and when markets do well, our portfolio value also will outshine.
If investor’s circumstances and market conditions change, asset allocation also
should undergo a change. Asset allocation is a forward-looking process.
Diversification is a useful concept
in finance. However, owning more than 15 to 25 stocks in an individual
investor’s portfolio does not make sense. If one is extremely intelligent and
knowledgeable about financial markets and has the required time and patience,
one can hold a concentrated portfolio of 10 to 15 stocks as suggested by Philip
Fisher.
Insurance companies have always
thrived on the principle of diversification – they collect premiums from a
large number of people and companies but pay only to a few. The total profits
will exceed the total losses from insurance underwriting, which is a long
gestation business.
Future is always almost uncertain.
There is always a risk of losing our hard-earned money. As human beings, we
have to make intelligent choices about our financial future. Being aware of the
risks involved, we have to move forward with our decisions.
As our investment goals are varied,
putting all our surplus money in a single asset class is risky. For
conservative and common investors, the time-tested principles of asset
allocation and diversification will, in all probability, provide an adequate
safety net in the face of adversity.
Depending on your temperament,
personal situation and available resources, you have to choose your asset mix
properly and diversify your investments carefully – knowing fully well the
limitations of asset allocation, your capacity and ability to understand and
gain knowledge of markets. Finally, the most precious thing is to have a good
night sleep!
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References:
1. The
Intelligent Investor by Benjamin Graham
2.
Against The Gods: The Remarkable Story of Risk by Peter L Bernstein
3. Common
Stocks and Uncommon Profits by Philip A Fisher
4. Investment
Analysis and Portfolio Management by Prasanna Chandra
5.
Investments by William F Sharpe
6.
The Age of Turbulence by Alan Greenspan
Disclaimer: The author is an
investment analyst & writer. His views are personal and should not be
construed as an investment recommendation. Please consult your certified
financial adviser before making any investments. There is risk of loss in
investments. The author is an equity/bond investor and he has a vested interest
in the market movements. His articles on financial markets can be accessed at:
