Asset allocation – what and how?

Don’t put all your eggs in one basket. We’ve heard this proverb. It’s the simple principle behind the fancy jargon called asset allocation.

It’s the best thing you can do for building your wealth over time but consistently and mindfully.

What is asset allocation?

Simply put, it’s how your wealth or assets are split between different ‘asset classes’ (being equities, debt, real estate, gold/commodities etc).

But you have to be mindful of a couple of things –

Most of the industry ignores your home. Some include other real estate such as vacation home while others exclude that too. Similarly, some people have most of their wealth tied up in their own business or ESOPs. Since these are hard to model, most financial advisers exclude these and refer to just the financial or investable portfolio when talking about asset allocation. It’s not right or wrong – it depends on the objective.

Secondly, remember we discussed a few approaches to financial planning –
the one timeline modeling approach where all our goals are put into one timeline and then we see how all our assets/liabilities are likely to grow to meet those goals
The goals-based approach where assets are matched to goals
The rule of thumb or heuristic method

Most people, when talking about asset allocation, assume that you are following the one timeline modeling approach, although of course, it’s worthwhile looking at the asset allocation for the other approaches too.

Types of asset allocation

Another thing to be aware of is the timeframe.

Long-term or strategic – 7-10 year timeframe, aiming to meet long-term goals
Short-term or tactical – 1 year timeframe, trying to time markets
Medium-term or dynamic – 2-3 year timeframe, adjusting when assets are extremely over or under-valued with the aim of reducing risk

SAA assumes long term returns from different asset classes, ignoring any current market valuations. So most MFs and WM will present a range of SAAs for different risk profiles…and you have to pick one that is most suitable to you. Risk profile, remember, is a combination of need, capacity and tolerance.

The problem with this is that market valuations are not stable. So most practitioners do SAA, and then do tactical deviations by going over/under weight based on relative valuations in the short term which is another way to estimate expected returns. But actually, saying something is expensive does not mean we know when it will mean revert so we don’t really know what the short term returns will be like. This is why short term predictions are mostly wrong.

The solution for most retail investors might be somewhere in between SAA and TAA – which is DAA. Here we adjust only to extreme over and under valuations …and mostly through cashflows rather than moving the portfolios around. So if we believe equities are extremely overpriced when we need to invest a lump sum, we allocate small amounts over time.

How to do asset allocation

The objective of asset allocation is to diversify.

So the steps are –

1. List the asset classes available for investments
2. Estimate their long-term expected return and volatility
3. Estimate how the returns are likely to be correlated ie how they might relative to each other
4. Come up with a ‘optimal’ allocation to each such that we minimise the overall portfolio volatility for a given level of return

These sound easy but are not.

Starting with listing asset classes. Equities is one asset class that has segments based on size of companies such as large mid and small cap. Are they really different enough with different return drivers? If not, we shouldn’t pretend they are multiple asset classes. In fixed interest, one could argue that government bonds and high yield bonds are different enough, since the former is driven by interest rates and the latter could be affected by corporate profits.

These points become clearer when doing the next steps. Can one estimate their long-term returns? Are they different enough from each other?

Estimating how their volatility and correlations is very hard. Most practitioners simply take historical data for this. Which is why sometimes we are surprised when the future turns out ot be different. A different way to do this is to think about what factors drive each asset class – like interest rates, economic growth, corporate profits – and ensure your portfolio is exposed to as many different factors as possible.

If the inputs are estimated well, the optimisation is mathematical.

Rebalancing is key in asset allocation

After spreading your assets ie doing asset allocation, chances are within a year the markets have moved so much that your report says you now have a different asset allocation. So should you bring it back to the SAA? If so, how often?

There are two approaches to rebalancing –

Time-based – say once a year or every 2 years
Range-based – when current allocations go more than x%, say 10% away from the SAA

Studies show that time-based approaches are good enough. So if you sit down once a year and rebalance, that’s a good habit.

Asset allocation is diversifying intelligently

In summary, asset allocation is about diversifying but not just randomly across asset classes. It involves doing some research and coming up with a view on which asset classes could do better over the time horizon we are aiming for. It also allows for the probability that the forecasts don’t turn out to be true.