Why Asset Allocation Is King…
Your mum was right, don’t put all your eggs in one basket!
Would you rather trust Sir John Templeton who once asserted: “the only investors who should not diversify are those who are right 100% of the time”, or Warren Buffett who, roughly, thinks that diversification is an efficient means of curing ignorance: “wide diversification is only required when investors do not understand what they are doing”? Well, both of them became billionaires: Sir Templeton by pioneering the use of globally diversified mutual funds and Warren Buffet by making very specific and successful bets…
As for me, being rather lucid on human beings, I believe that Warren Buffett’s principles are not applicable to anyone unless they are a financial markets wizard or an investor ready to take extremely high risks… My preference has always gone to Sir John Templeton’s philosophy and I must admit that recent market turbulences have strengthened the sentiment that diversification is key to monitoring risk and maximizing wealth preservation. So, in my view, all asset classes do have a place in a portfolio, but questions remain: what is the proper place for each and how can an investor get the best of each?
That is exactly what Strategic Asset Allocation (SAA) is about: a structured approach, based on efficient diversification that aims to maximize performance at constant risk over the long run. In other words, SAA helps resolve the difficult trade-off between risk and performance.
AN UNCERTAIN ENVIRONMENT
The past 10 years have been a roller coaster ride in financial markets and higher uncertainty is likely to be a permanent feature of the market for years to come. To cope with such an environment, it is no longer sufficient to buy and hold stocks or bonds in an opportunistic manner to weather market shocks. No, I believe that, first of all, before thinking of investing in single products, investors have to step back and define and build, at asset class level, the most appropriate portfolio structure, according to their investor profile. This is called Strategic Asset Allocation and provides an efficient way to preserve capital over the long term. To do that properly, you will have to ask yourself upfront several key questions: what is my performance target, what level of loss can I accept, what are my liquidity needs, do I have specific deadlines (like retirement) or projects (such as buying a house in the mid-term)…?
FINDING THE RIGHT ASSET MIX
Then, according to these objectives and constraints, the next step is to define the right asset mix. More precisely, this is about leveraging three key parameters:
- First, understanding the specific risk-return profile of each asset class. For example, equities' performance is much more volatile than that of bonds.
- Secondly, assessing each asset class’s sensitivity to economic factors. Typically, equities do well during times of growth, but commodities do better during times of inflation.
- And, last but not least, measuring the intensity of connections between the different asset classes to combine them in the most efficient way. This is called correlation.
Let us talk a little more about this last point: the goal here is to build the perfect asset mix in order to benefit from the correlation effect. To make it simpler, two asset classes can evolve in a very similar way (correlated) or in opposite directions (negatively correlated), or be completely independent from one another (independent/de-correlated). For example, under normal market conditions, equity markets – whether developed or emerging, large cap or small cap - are strongly correlated with one another. On the other hand, equities and bonds are usually negatively correlated. On the graph below, we see an example of the performance of the DJ Europe 600 index versus a diversified portfolio including not only equities but also bonds, real estate and alternative assets. As you can see, the diversified portfolio performed better during periods of market turmoil. That’s because diversification protects the portfolio against the swings of a single asset class and makes it more resilient during downturns, therefore delivering greater returns over the long term.
A PORTFOLIO TAILORED TO SPECIFIC NEEDS
Of course, depending on the initial long-term requirements, the most relevant strategic asset allocation may vary. For example, let’s say you are about to retire, after investing for 30 years. In such a context, your major worry will be to clarify and optimize your portfolio structure to pass it on smoothly to your children. Your “ideal” allocation will be completely different from that of an investor who has just entered working life, has children to educate and envisions important real estate projects. However, for both of you, the SAA process will follow the same path: help you take a step back and answer key questions to eventually build the most efficiently diversified portfolio.
A CORNERSTONE IN PORTFOLIO CONSTRUCTION
To conclude, I am not saying that, with Strategic Asset Allocation, you will avoid all market troughs. I am simply saying that making big bets on only a few ideas is usually a risky investment strategy, except if you are the new Warren Buffett (which I wish you the most!); I am simply saying that building the right asset mix upfront, in line with your personal objectives, is a critical step to help you preserve your wealth. So, in a nutshell, SAA is a cornerstone in a wealth management strategy.
Finally, keep in mind my four golden rules:
- THINK LONG TERM: be strategic before tactical, avoid being caught in a buy-and-sell spiral, and do not forget that strategic asset allocation is a critical source of performance stabilization;
- ASSESS RISK THE RIGHT WAY: ask yourself key questions, define your risk aversion, be aware that without risk there is no return, and use various indicators to assess risk (volatility, illiquidity, maximum accepted loss);
- DIVERSIFY: remember that each asset class has something to bring to a portfolio, build the right asset mix, and bear in mind that always being right is difficult;
- THINK GLOBALLY: do not be short-sighted, get the global picture, clarify your global investment strategy taking into account all your preferences and constraints, and always take a step back before going into any investment decision.
Now that you know all the basics on Strategic Asset Allocation, please stay connected to find out more in the coming weeks!