Asset Allocation – The importance of portfolio diversification for your investments

How asset allocation and portfolio diversification can improve the risk-reward ratio

Effective asset allocation is vital for any long-term investment strategy. While the stock market has historically delivered superior investment returns over time, portfolio diversification across a range of stocks and other asset classes is needed to reduce volatility in the short term and improve a portfolio’s risk-reward ratio over the long term.

What is asset allocation?

Asset Allocation
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Asset allocation involves spreading an investment portfolio over a range of asset classes to improve returns and reduce risk. As a form of portfolio diversification, asset allocation is all about adjusting the mix of assets in a portfolio to control the expected volatility. Effective asset allocation allows the balance between the expected risk and return of a portfolio to be optimized according to the time horizon of an investor.

The following are examples of conservative and aggressive asset allocation mixes:

  • Portfolio A: Equities 20%, Bonds 70%, Cash 10%
  • Portfolio B: Equities 70%, Bonds 20%, Cash 10%

With a higher allocation to stocks, Portfolio B would probably outperform over the long term. However, it would also have higher volatility and could underperform over periods of 5 years or less. While Portfolio A may underperform over the long term, it would be less likely to lose money over shorter timeframes.

Portfolio diversification can be implemented at the portfolio level or at the asset level. At the portfolio level capital is traditionally split between equities, bonds and cash or short-term money market instruments. Other assets can also be added to further diversify a portfolio. A fixed income portfolio can be diversified by investing in a mix of government bonds from different countries, corporate bonds and high yield bonds. The portfolio can be further diversified by investing in interest rate products of different maturities.

Why asset allocation is important

Stocks generally do generate higher returns than other asset classes. However, if investors put all their eggs in one basket, they are exposing themselves to a high degree of risk in the event of a stock market crash.

Volatility
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In 2008/2009 many stock portfolios lost well over 50% of their value. That means they needed to gain 100% just to return to their value before the financial crisis. When one considers that long term equity returns for US stocks are around 7 – 8% a year, that implies at least 10 years before those losses are recovered. When investing to save capital toward long term financial goals like retirement, it’s important for investors to consider the amount of volatility they can accept. On the other hand, capital growth requires investing at least part of a portfolio in riskier assets.

Younger investors saving for retirement can tolerate higher volatility as they have time for a portfolio to recover and will not need to access the capital for some time. At the same time, they need to own riskier assets to build their portfolio from a small base. By contrast, older investors nearing retirement age will need access to their capital sooner. They cannot tolerate the same amount of volatility and will need to hold more of their portfolio in low risk assets. Asset allocation allows portfolio managers to find the right balance between risk and reward for an individual’s portfolio according to their unique requirements and time horizon.

Instruments within each asset class are highly correlated with one another. Within the stock market, a stock’s return is a function not just of the company’s profitability, but of the stock price movements of its sector and of the broader stock market. However, assets generally have lower correlations with assets from different asset classes, and in some cases can be negatively correlated with one another. Through portfolio diversification the overall volatility of a portfolio can be reduced. When one instrument loses value another may gain in value or at least lose less value.

Portfolio diversification can also lead to higher overall returns. A portfolio that loses less value may generate higher dollar returns when asset prices recover. Empirical evidence suggests that asset allocation has a larger effect on a portfolio’s returns than the selection of individual investments does. A diversified portfolio can also weather changing market conditions better than individual investments as gains in one asset can offset losses in others.

Risk versus reward

Risk / Reward Ratio
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Over time investors are rewarded for taking on risk, and higher returns require investors to take on more risk. While there are several types of risk, for investors the risk of permanent loss of capital and temporary impairment of capital are most relevant. Investors can mitigate the permanent loss of capital by investing in profitable companies and assets with tangible value, or by spreading the risk through portfolio diversification.

Temporary impairment of capital comes in the form of volatility with riskier assets exhibiting more volatility than less risky assets. Investors only lose money after a market crash if they sell their investments at a lower price than they paid for them. Provided a portfolio is invested in quality assets, the portfolio should recover. However, this may take time. An investors time horizon is therefore a critical factor in deciding how much risk they can tolerate. Any potential short-term capital requirements also need to be considered and invested in cash-like instruments only.

Ways to diversify a portfolio

There are several approaches to diversifying a portfolio depending on the size of the portfolio, the investment goal and how actively the funds will be managed. A very simplistic rule of thumb for diversifying your portfolio is to allocate 100 minus your age to equities, and the rest to bonds and money market instruments. While this is oversimplifying the process, it’s not actually very far from a moderate asset allocation model.

Strategic asset allocation

Asset Allocation / Portfolio Diversification
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Strategic asset allocation is a long term relatively passive approach. A fixed percentage of the portfolio is held in each asset class, usually via ETFs. The portfolio is rebalanced at regular intervals, or when it gets too far out of line with the desired allocations. The extent to which the portfolio is diversified will depend on the time horizon of the investor and their specific investment goals. Over time small incremental changes may be made to the asset allocation model, usually to reduce the risk as an investor approaches retirement age.

Tactical asset allocation

Tactical asset allocation is a more active approach in which allocations are adjusted based on market conditions and the relative valuations of various asset classes. This approach is often used within the equity portion of a fund to move capital from overvalued to undervalued sectors, countries or regions. Doing this effectively can significantly improve the risk-reward profile of a portfolio.

Tactical asset allocation can also be implemented by using momentum. With this approach the allocation to each asset class only remains invested when prices are rising. A moving average can be used as a trailing stop, and when the relevant instrument’s price falls below the moving average the allocation is moved to cash or another asset class.

Mutual funds / Exchange traded funds

Analyzing Financial Figures
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Individual investors with smaller portfolios can achieve quite a lot of portfolio diversification using mutual funds and exchange traded funds. An index fund, whether it comes in the form of a mutual fund or ETF, that tracks a broad market index like the S&P 500 can remove a lot of the investment risk carried by individual stocks. But it won’t eliminate market risk. Investors can achieve broader portfolio diversification by allocating capital to global equity funds and multi asset class funds.

Target date funds

Target date funds are designed for investors with a specific time horizon in mind. These funds gradually adjust the asset mix to reduce risk and volatility as the target date approaches.

Robo advisor platforms

Robo advisor platforms use automated models to match an investor’s investment goals and needs with an appropriate mix of assets. Investments are usually made using ETFs and are automatically rebalanced at regular intervals. The platforms are somewhat simplistic but generally satisfy the needs of smaller investors at a low price.

Using alternative assets for portfolio diversification

Asset Allocation Concept
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Besides traditional asset categories like equities, bonds and cash, greater portfolio diversification can be achieved by also allocating capital to alternative assets. Alternative assets include hedge funds, private equity funds, venture capital, real estate, commodities, currencies and even art and antiques. These asset classes have very low correlations to traditional assets. If chosen carefully, they can generate respectable returns in their own right.

The more alternative assets a portfolio includes the less it will be impacted by stock market volatility. However, traditional assets can be expensive to invest in, require specialised knowledge and are often illiquid. For most investors’ real estate funds and hedge funds are the most accessible and practical alternative assets to invest in. Hedge funds, particularly market neutral funds and long/short funds, are specifically designed to have a low correlation to other asset classes and can perform well during bear markets.

Market neutral funds hold long and short positions so that the net exposure is close to zero. Their performance is not dependant on that of the broader market, but on the relative performance of long and short positions. They also tend to have lower volatility than traditional equity funds. Market neutral funds can vastly improve the performance of a portfolio when combined with a traditional stock portfolio. Long / short hedge funds are more flexible and can be net long or short. Some funds also use leverage to enhance returns. These funds can perform very well in both bull and bear markets, but may have higher volatility than market neutral funds.

When to consider portfolio rebalancing

Portfolio Rebalancing
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A proper asset allocation strategy requires a portfolio to be rebalanced from time to time to ensure that the correct amount of capital is allocated to each asset class. As an example, let’s say a portfolio is split 60/40 between equities and bonds. If the equities gain 20% while the bonds gain 3%, the split will now be 63.6/36.4. While that is not very different from the target mix, if the outperformance continues, the equity portion will quickly grow.

An instrument or asset class that is outperforming will often continue to outperform. However, holding an overweight position in that asset class will also lead to increased levels of risk. At the same time, the allocation to the underperforming asset will shrink. When that asset begins to outperform its ability to contribute to performance will be impaired. Exactly how often a portfolio should be rebalanced is a somewhat controversial topic. Most funds are rebalanced every quarter, while some believe rebalancing annually is often enough.

In fact, the frequency is less important than making sure the weighting of each asset isn’t too far from the target. Adjusting each holding when it’s weight changes by 5% should keep the portfolio in line. So, if a holding is supposed to be 60%, but grows to 65%, it could be time to reduce the holding.

Best practice for portfolio diversification

Asset Allocation / Investing
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There is no one size fits all approach to portfolio diversification. When devising an asset allocation strategy, the most important job for financial professionals is determining each client’s financial situation. This includes their risk tolerance, current financial needs, future financial needs and time horizon. Only when these realities have been ascertained an effective asset mix can be determined.

An allocation strategy should err on the side of being conservative and generally shouldn’t be based on market timing models or on taking a view on the market. Tactical asset allocation strategies are more active and therefore need to be systematic, well tested and vetted. The ultimate goal of rebalancing should be to find a balance between minimizing risk and minimizing costs. Frequent rebalancing is not necessary if there have not been large price movements, and the increased cost makes it counterproductive.

As far traditional long only equity portfolios go, the marginal benefit of adding more stocks falls rapidly once the number of holdings reaches 20 to 25. However, adding other asset classes will continue to improve the risk-reward profile, provided the other assets are legitimate investments in their own right.

Conclusion: Asset allocation can improve a portfolio’s risk-reward ratio

Asset allocation decisions often have more impact on a portfolio’s performance than individual security selection. Combining uncorrelated assets can not only reduce volatility but improve returns over time. A traditional asset mix will contain equities, bonds and cash. Adding alternative assets like real estate and hedge funds, especially Big Data and A.I. driven vehicles like the Data Intelligence Fund, can provide a unique opportunity to further reduce volatility.

About Richard Bowman
Richard Bowman is a writer at Catana Capital, analyst and investor based in Cape Town, South Africa. He has over 18 years’ experience in asset management, stockbroking, financial media and systematic trading. Richard combines fundamental, quantitative and technical analysis with a dash of common sense.

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