All investors must have a sensible asset allocation if they are to get the best out of their savings. Even more important than making the right investment selection is the need for a strategic asset allocation.
1) Asset allocation is not diversification
Investors tend to use the terms interchangeably. Often they pack their portfolio with 15-20 funds and believe they have achieved both.
Asset allocation is the process of determining the right mix of investments you should own. In other words, how much of exposure you need to have to various asset classes. At the most fundamental level, they are equity, debt and cash. It can further be built up by looking at other asset classes such as gold, commodities, real estate, art, private equity, and collectibles.
On the other hand, diversification is what you invest in within these asset classes. For instance, you may decide to allocate 65% of your portfolio to equity. Figuring out how to invest your money within this asset class is where diversification comes into play. This would entail deciding on the number of equity mutual funds to hold; the mix between growth, value, infrastructure or other sector funds; how many large- and mid-cap funds; as well as whether or not to have an international fund to gain global equity exposure.
If you decide to go with just one equity fund, a 65% exposure to a single fund shows no diversification at all, despite the fact that you have planned a sensible asset allocation.
2) Asset allocation could be tactical
An investment strategy generally refers to a consistently executed long-term plan. For example, a mutual fund that routinely invests in stocks its fund manager believes are underpriced may be said to employ a value strategy. This could be the fund manager’s core strategy.
While maintaining this as the core strategy, the fund manager may see opportunities that are short-term in nature but have the potential to increase returns. This is called a tactical approach. Such moves may be based on what the manager thinks is happening or will happen in the markets and typically are aimed at boosting gains.
For instance, this value fund manager may latch on to a few growth stocks for the short term because a strong rally is on. Or, he may believe an uptick in infrastructure stocks would take place and may decide to focus a part of his portfolio on a few such stocks. These are essentially short-term moves that would add alpha to the fund without affecting the fund manager’s overall strategy.
Of course, some fund managers tactically reallocate assets more than others. Some may see it as an essential part of their overall approach, others may not give it that much importance.
On a personal front, an investor too can employ a tactical approach. Let’s look at bond funds for instance. Longer the maturity of the bonds in a portfolio, the higher its duration; the higher the duration, the more sensitive is the bond’s price to the fall in interest rates. So debt funds with a shorter duration of a year or so can be used for a strategic allocation. The long duration funds can be a tactical allocation.
In equity too such tactical allocations can be made, however do remember that should you sell before a year, your investment will be subject to short-term capital gains tax.
3) Asset allocation is not standard
No preset allocation or tool can possibly address the many variables that factor into an appropriate asset-allocation framework. A 62-year-old with limited investment assets and poor health who intends to retire next year will, very likely, need to invest differently than a wealthy entrepreneur of the same age and expected retirement date.
This concept holds true from the standpoint of job stability, as well. A college professor in a reputed institution with a stable job could afford to have a more aggressive asset-allocation mix than someone in a profession with a more volatile income stream. For example, commission-based salespeople and those starting businesses might find their incomes are unpredictable from month to month. The volatility of their income streams argues for having a larger emergency fund than the typical prescription of three to six months' worth of living expenses, as well as a more conservative long-term asset allocation in case those emergency reserves are depleted.
Also to be taken into account are the issues of other income-producing assets in a person's retirement programme, such as a pension or an income annuity or rental income.
When taking into account all such issues, the need for customised asset allocation is all the more significant.
4) Asset allocation could be dynamic
The inability of a static asset allocation mix to accept new information is the dominant cause of unrealised return expectations. An optimal portfolio should reflect the most recent changes in expectations with a dynamic asset allocation model.
At Morningstar, we dynamically allocate across assets using long-term economically justified relationships between asset prices, valuations, and fundamentals. Our approach recognises that there are times when the reward for taking risk is low relative to history, and at these times the portfolio should reflect this and hold more cash or other low-risk assets. This approach means that the ‘riskiness’ of assets can and does change.
While we cannot predict when the markets will price assets on the basis of their valuations and underlying fundamentals, we believe that using a patient and disciplined approach provides superior long-term real returns.
When we assess assets, we seek to determine a fair return over a 5- to 10-year period, using trend fundamental and valuation levels, adjusted for structural changes and expected economic environments. We then compare these expected returns to history, to provide a guide as to whether the assets are expected to provide better than average returns. When looking at the risk of investing, we look beyond measures of volatility or probability of negative return, which generally measure return fluctuations. While return fluctuations are important in quantifying risk, we believe valuation and fundamental risks are critical in determining a broader and more meaningful assessment of the risk of an asset.
5) Asset allocation needs periodic rebalancing
Your portfolio's actual allocations will fluctuate year-in and year-out depending on market movements. All else equal, assets that have performed well will consume a bigger share of your portfolio's value, and assets that have done poorly will shrink. For instance, you may have decided to allocate 5% of your equity portfolio to U.S. stocks. But the impressive performance of the U.S. stock market might have resulted in the U.S. stock allocation being oversized compared to the targeted amount. It could be the same between equity and debt.
Once you've set your asset allocation, it's important to periodically revisit your portfolio's actual asset allocation to make sure it's still on track. It's a given that some parts of your portfolio will perform better than others; periodically rebalancing back to your targets can help reduce the volatility in your portfolio.
Additionally, you'll need to revisit your own target stock/bond/cash mix as the years go by. For most investors, getting closer to their goal dates will necessitate a more conservative asset mix; as they get closer to spending what they've saved, they can't risk big fluctuations in the value of their nest eggs. So if you're getting close to retirement and notice that your stock allocation is dramatically above your target, de-risking your portfolio is particularly important.
