Thinking About Asset Allocation

It is almost a platitude to say that the way we put together a mix of assets is the fundamental decision in investing. In this context, Mark Twain’s famous quote is worth recalling: ‘If you want to be rich, put all your eggs in one basket – but watch the basket very carefully!’ Alternatively, another principle is ‘do not put all eggs into one basket’.

The fi rst advice applies to entrepreneurs, who believe they have special know-how about a particular market segment that allows them to earn superior returns, not available to others. Anyone who is not convinced about his or her abilities in this regard is well advised to follow the alternative principle of ‘diversifi cation’.

Traditionally, savers have to make a choice among fi ve basic investible assets:

¦ Money (various bank deposits, money market instruments)
¦ Fixed Income instruments (notes and bonds)
¦ Equities (and equity-like instruments)
¦ Real Estate
¦ Contracts on Commodities

Conventional portfolio management entails combining assets, so the resulting portfolio off ers maximum expected returns for a given level of risk. The risk is measured by historical volatility that focuses on the degree to which the investment return has deviated in the past from average returns. To reduce the overall risk, portfolio management theory introduces the concept of diversifi cation, based on the imperfect correlation of individual assets in the portfolio. The lower the correlation, the higher the diversifi cation, the lower the overall risk and vice versa. Today, ‘optimisers’ are readily available¹.

The problem, of course, is that correlations are not stable. The famous story of the statistician who drowned in a river only three feet deep, on average, applies here too. Correlations change slowly over time as external circumstances change, for instance, when international economic integration progresses. Even more seriously, correlation increases dramatically during periods of crisis. The period of 2008/ 2009 will serve as a textbook example for many years to come.

So what advice is the advisor suppose to provide?

The typical textbook description is to fi rst assess the risk preference of the client-investor. Every institution nowadays has a questionnaire that serves to elicit the client’s risk preference. The problem is that the response is based on vague ‘feelings’ – not facts. Here is where the advisor can make a contribution: teasing out of the client suffi cient information that allows an assessment of his or her ability to bear risk. To illustrate, a young person at the beginning of his or her career is poorly served with a ‘conservative’ retirement portfolio heavy with bank deposits and short-term fi xed income paper, even though the person may express much anxiety about losing money. Obviously, many factors play a role here and simply checking boxes is of little use.

Here are a few comments on issues often overlooked in public discussion. Firstly, there are no riskless investments! Even bank deposits are at risk, primarily due to infl ation and under rare circumstances there is default risk due to bank failure and/or government default. Last but not least, the use of the funds may be restricted by government exchange controls! Money market funds, where they exist, are subject to similar credit, liquidity and political risks.

Bank deposits and fi xed income instruments are denominated in a particular currency which gives rise to special diversifi cation challenges. Rather than trying to engage in useless discussion on whether currency X is going to strengthen or weaken, the advisor should instead focus on the client’s future ‘exposure’: where will you be retiring? Are there children who may wish/ need to be educated abroad? Special circumstances such as medical needs abroad? The composition of the future consumption basket is what counts, recognising that while we pay for almost everything in Singapore in our local currency, oil prices are pegged to the US dollar and not the Singapore dollar!

What is less known in this respect is that equities (and to a certain extent equity related hybrids such as preferred shares and convertibles) have no currency denomination! While they are traded on an exchange and are both quoted and settled in a particular currency, normally the currency of the country of the exchange, prices do react instantaneously to currency changes. For example, a strengthening of the Yen leads almost invariably to a weakening of prices on the Tokyo Stock Exchange, assuming currency changes are not dominated by other news. Thus, equities are poor tools to achieve currency diversifi cation!

One important aspect of equity investment is based on the fact that shareholders are ‘residual claimants’ i.e. they receive only a reward for their risk capital if all other claims by suppliers, employees, creditors, government and managers on the fi rms’ net revenues have been satisfi ed. This makes corporate governance a major issue in valuing equities: how ‘shareholder friendly’ is the company being managed? How investor-friendly are the rules in practices in the country where the company is headquartered?

Real estate investments are complex. They come in both paper form (REITS, mortgage-backed securities, etc) and physical form. In this regard, investors often overlook that the home in which one lives in is a consumption good, not an investment asset – except for very old people when there is a realistic expectation that the home becomes part of the estate in a reasonably short time.

Finally, there is the problem of home-bias. In all countries, investor portfolios are heavily weighted with domestic counters. The reason is clear – people like the familiar names, operating under the illusion that they have insights into the value of the companies.

From a risk management and asset allocation standpoint, that makes little sense. If there is a problem in the investor’s home country, his stock will lose value at the same time when his or her job is in jeopardy, or at best, his or her take-home-pay may be less when compensation is fl exible.

So what is the investor supposed to do? Fortunately, there are now easy solutions to the dilemma – low-fee Exchange Traded Funds (ETFs) that provide diversifi ed access to many foreign markets. In this respect, the writer is no friend of the mutual fund industry. To an extent that managers have the skill to outperform indices, they tend to appropriate the value created to themselves in the form of hefty fees!

This brings us to the fi nal issue. During the last years, ‘alternative investments’ have been added to the mix of assets to be considered, comprising commodities, hedge funds, private equity arrangements and even art objects. What has been said about mutual funds applies to most of these asset classes even more. The idea that there are people who endeavour to make money for others is an illusion; operators make money primarily for themselves and only occasionally is there something left for the poor saver who entrusts his/ her hard-earned money to others to invest. Caveat emptor!

Professor Emeritus Gunter Dufey hails from the University of Michigan, Ann Arbor, USA, and is a Professorial Fellow at the Nanyang Technological University (NTU) and Nanyang Business School (NBS). He is an Honorary Member and Advisor of the Financial Planning Association of Singapore (FPAS).