What asset allocation is, what it is not

For asset allocation strategy to work in your favour, investors must include all assets

Published 4 years ago on Mar 27, 2020 6 minutes Read

Remember XYZ stock I told you about three months ago? It is up by 80% since then”, “ABC ekdum solid hai. Just jump in”, “PQR kya lagta hai?” Sounds like a familiar party conversation…or something that you watch financial channels for.

If your endgame is to have fun discussion at parties, this is fine. But if your purpose is to protect and multiply your wealth, or to optimise your portfolio, you are frankly approaching the problem from the wrong end! Why? The answer takes you to Investing Basics 101. And, it is to do with asset allocation. Depending on the study you read (and there have been many, conducted over decades), you will find that fully 85-92% of the returns of a portfolio come from asset allocation.

You got that right!
Specific stock selection, which eats up most of your and your advisor’s waking hours contributes only 10-15% of the return. Moral of the story: it does not make sense to concentrate your resources and time on security or stock selection. But, all the talk you will hear from portfolio managers is about how good they are at picking stocks and great bottom-up winners.

The uncomfortable point is — bottom-up stock picking is a very, very difficult art, and nobody in the history of investing has been able to do it successfully for decades. Yes, not even Warren Buffett.

Just go and look at his record in the past 15 or 20 years and you will see an investor who has missed practically every single multibagger that the US market has given in this period: Amazon, Netflix, Domino’s, Google, Apple (he bought way too late), Facebook, Microsoft, and so on. He is an investor who has consistently underperformed the stock indexes.

This is PRECISELY the problem with the ‘sexy’ bottom-up stock-picking approach. Everybody is relevant in a period. And one fine day, the market changes, and you and your strategy become irrelevant.

Therefore, when you are picking people to manage your money, check the approach and their strategy.

The golden key to investing
Most investors fall in the very familiar trap of getting over exposed to the hot asset class of that era. But the key point to always keep in mind is that if you start playing every innings thinking that you are going to get a hundred runs, you are never going to be successful. Markets change; sometimes they become easy, sometimes very tough.

The key to successful investing, over the long term, is to have every major asset class in your consideration set, across countries and currencies and across investible assets — equity, fixed income, real-estate, precious metals, other commodities and more.

The mantra: there is always a bull market somewhere in the world, even as there is a bear market elsewhere at the very same time. View this: Technology in 1998, Emerging Markets in 2004-07, Commodities 2003-08, US equities- tech 2010 onwards, Japan 2013-15, Global Fixed Income 2009 onwards.

Even more recently, 2018 and 2019 have been extremely difficult periods for Indian stock markets. Barring a handful of stocks, most have been in negative territory. Despite the difficult 2019 period, First Global’s global portfolio returns have been up 40%!

That’s the beauty of asset allocation.

To optimise your portfolio, it is important to have all asset classes in your consideration set and carry out dynamic and tactical asset allocation.

What asset allocation is not

The phrase ‘asset allocation’ is bandied around rather casually these days. Hence, it is important to understand what asset allocation is not.

We see this phrase being used quite lightly by many financial advisors and fund managers claiming to do asset allocation strategies. Only when one goes somewhat deeper into it, one realises that all the talk is about the nature of large-cap versus small-cap Indian stocks or moving from value strategies to growth strategies in terms of stock choice within the Indian market. This, combined with some debt allocation, appears to be the philosophy underlying the so-called ‘asset allocation’ strategy.

In fact, some of the investment documents even cite the same studies that we mentioned — 85-92% of a portfolio return comes from asset allocation, with specific stock-selection contributing only 8-15%. The problem? The studies cited take into account a portfolio consideration set that is across countries and across asset classes, not just couple of asset classes in a single country!

So, for asset allocation strategy to really work in your favour, your consideration set must include all assets — developed market equities, emerging market equities, developed market fixed income, gold and precious metals, other commodities, real-estate (REITs) across countries and so on.

Just changing allocation across different categories of the Indian equity market or even Indian equity and debt markets is simply not good enough. That is like playing football on 20% of the football field. It might be better than not playing at all... but can it really be called football?

Hence, it is important to look at asset classes beyond just debt and equity, even within the Indian markets. For instance, let us look at the past 10 years. In two years, gold was the best performing asset class in India (partly due to currency movements), and in another year, it was the second-best performing asset class. In other years, real estate did extremely well. And now, through REITs and some other instruments, it is possible to get systematic exposure to real-estate as well.

When we, at First Global, talk of ‘asset allocation’ it means that your consideration set has practically all the investible asset classes in the world.

The other key is to have a dynamic and tactical asset allocation model, that is, assets are to be reallocated based on the tactical view of various asset classes at any point in time. Just crude measures — like at an age of X years, you should have 60% exposure to equity and 40% to debt — simply don’t work, if you are looking to protect and multiply your wealth.

An in-depth understanding of the underlying asset classes is also important. Among other things, this is to ensure that asset classes are largely not correlated. That comes from data and vast experience. Is your money manager well-versed across asset classes, across countries, across currencies? If not, you need to be very careful because you may be getting trapped into the narrow expertise of your money manager, which is fine for him, but can be disastrous for your portfolio.

For example, if one has a positive view on commodities and a positive view on Brazil and Russian equity markets, increasing exposure to both will most likely be correlated as commodity prices drive many of the large company earnings in these two markets.

Currency alone, or a single country exposure, can also change your portfolio return profile dramatically.

To conclude, investing is about batting like Sunil Gavaskar: a steady, decidedly ‘unsexy’ approach of careful risk management through diversification across asset classes… just like Gavaskar played shots all around the wicket, hit both pace and spin balls with equal mastery, and also batted well across the world.

Bottom-up stock picking is a bit like Virendra Sehwag: brilliant when it works, terrible when it doesn’t. But, never steady or predictable. So, runs come with high volatility or standard deviation.

Who would you want managing your money: Gavaskar or Sehwag? The answer is obvious, isn’t it?

Devina Mehra and Shankar Sharma are co-founders of First Global, a global PMS and securities firm