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Get Insulated With The Right Asset Allocation Policy
Education | 26 August 2011
By: Choo Hao Xiang
Articles (151) Profile
By: Ong Qiuying
Articles (131) Profile

As Mr Bear is out staging a bear-raid, it may no longer be a good idea to keep all your honey in a jar. While you can hide the honey jar when you think Mr Bear is lurking around, such fortunate coincidences of catching that right timing do not always come by. Perhaps putting your honey into many jars and hiding them in different parts of the forest, or even bartering some of it for items less appealing to Mr Bear, could save your honey from the hungry bear.

Today, this concept of diversification is very much valued and applied widely, especially in the financial realm where investing in a variety of assets has always been advocated by experts as a way to achieve maximum returns for a given level of risk. Still, asset allocation is one diversification tactic that has been employed very sparingly among investors.

Be it funding constraint or failure to assess the risks involved, this is one step that investors should not miss out. According to a study by Ibbotson & Kaplan (2000), 90% of the variability in returns of a typical fund across time is explained by target asset allocation policy.

Protection Of Investment Returns

There is an ever increasing need for investors to have a long-term view, with an emphasis on the protection of their portfolio returns by diversifying risks. This is in light of what investors had witnessed during the past few weeks in the global equity markets, which left them struggling to keep their investments afloat.

As you might have guessed, one can diversify his exposure by dividing his funds across 3 main types of asset classes:

  1. Cash and equivalent
  2. Fixed income – Government bonds, corporate bonds
  3. Equities

Through the application of asset allocation, losses from one asset class can be cushioned by gains from other types of investments. This is because asset allocation works on the premise that the relationships between the returns from different classes of assets are not in perfect synchronisation.

Individual Circumstances

Before we proceed any further, there are a few considerations that need your attention. Factors such as investment goals and time horizon, as well as risk appetite will be the basis for the portfolio construction for each individual. Based on these points, the decisions involved in the asset allocation process include:

  1. What are the asset classes that should be considered?
  2. What policy weights should be assigned to each asset class?
  3. What are the allowable allocation ranges based on these policy weights?
  4. What are the specific securities/funds that should be purchased?

Table 1: T. Rowe Price Matrix
Table 1: T. Rowe Price Matrix
Source: T. Rowe Price

For instance, based on the T. Rowe Price Matrix, an investor intending to invest over a period of 6-10 years with a moderate risk tolerance can apportion 20% of his funds to cash, 40% to bonds (e.g. an equal combination of government and corporate bonds) and the remaining 40% of the funds to stocks (e.g. 25% in high yield plays and 15% in growth stocks).

Stock Portfolio

Going deeper into one’s equity portfolio, one can distribute his funds further among the different types of stocks based on their business sectors classification. In view of the current market volatility, the focus of this section will be on having a good combination of high yield plays and growth stocks. Generally, investments should also comprise of stocks with large market capitalisation due to their ability to mitigate volatility, hence, offering more stability compared to their counterparts with smaller capitalisation that are more susceptible to price fluctuations.

Investors who are more risk adverse may wish to weigh their equity portfolio towards defensive stocks such as those in the consumer services sectors like telecommunications as well as healthcare sectors, and real estate investment trusts (REITs). As consumers do not have as much discretion to eliminate purchases in these areas, these stocks tend to have a relatively stable performance regardless of market conditions. As seen from the chart below, the stock prices of companies operating in these sectors were able to weather the recent sell-down, performing better than the benchmark, Straits Times Index (STI).

View Full-sized Image
Source: Factset

Other than yield plays, high growth stocks represented by companies at the early stages of their business life cycle, or with a growth potential due to a growing market for the products and services, could also be included in the portfolio.

Table 2: Dividend Yield
Source: Factset
Source: Factset

During periods of economic expansion, growth stocks tend to perform better than yield plays in terms of capital gains. Supported by strong demand as economic activities pick up, sectors such as oil and gas as well as commodities are well-positioned to benefit from the growth.

The growth strategy has seen its fair share of success. For example, over the last decade, the United Growth Fund has returned 8.2% a year (including the 5% sales charge), outperforming the STI, which gave a return of 7.4% a year over the same period.

Having said that, such cyclical stocks can be quite sensitive to economic fluctuations and could exhibit more swings correlated with the overall business cycle. Hence, investors should try to buy these stocks before the upturn and sell them before the downturn, or allocate a smaller portion of funds to growth stocks during volatile times.

In addition, investors can also diversify their portfolio geographically, selecting stocks that have high exposure to certain regions, internationally, regionally or domestically, to tap into favourable economic conditions significant to each region.

Sticking To The Game Plan

Once the portfolio is set up with the suitable asset allocation policy, one needs to monitor his portfolio on a periodic basis (6-12 months) so as to keep the investment returns in line with one’s investment objectives. The review should reflect any changes in situations whereby the portfolio’s risk profile drifts away from the investor’s risk tolerance. Put simply, one can either take profit and transfer the gains into other asset classes or inject new funds into other asset classes to bring the portfolio into balance.

That said, it is definitely easier said than done. Investors should see rebalancing as a form of risk control and protection of the investment gains so far. If one were to let the portion of the outperforming segment grow continuously, he will feel the pain when that particular segment gets hit, especially when that segment accounts for a significant percentage of the entire portfolio.

Indeed, asset allocation is a good way to outsmart Mr Bear and it is highly recommended that investors stay prudent and weigh their equity portfolios towards high dividend yield plays, at least for the time being. However, it does not necessarily rule out other factors affecting the portfolio now that one has a few pots of honey and even baskets of fruits. Needless to say, the presence of an emergency fund would help investors tide through any short-term difficulties and help ensure that there is no rash decision-making.

This is a co-written article of Shares Investment, which lays out the analytical ideas and thoughts of the authors, who are well versed in investments and market concepts.

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