The first step of asset allocation – the strategic step – is finding an asset allocation breakdown that meets your individual needs. This means that you should end up with a breakdown that you can live with no matter what happens in the market; even in the case of an extreme shock triggering a temporary markdown of the portfolio. You should not lose sleep over your investment portfolio.
Market shocks
Markets are subject to shocks every once in a while and the risk premia investors are vesting by investing in bonds, equities, and other types of financial investments fluctuate all the time. This triggers ups and downs and mark to market volatility in portfolios. In the case of external shocks, which can be pretty extreme, the temporary impact on the portfolio can be quite harsh. The other case when portfolios suffer a significant drawdown is when the economy goes into a recession. Your strategic allocation should be such that you can survive these events in the markets.
Risk and return
The first question you need to ask yourself when deciding upon your asset allocation is ‘what is my investment objective’? Here, the most important step is defining your risk tolerance, as you will calibrate your asset mix as a function of the amount of risk you are willing to take. The return of the portfolio over time will be a function of the amount of risk you have been willing to accept or not.
Forward-looking approach
Once you have defined your risk tolerance, you can begin allocating your assets. There are various ways to build an asset allocation, but the one way that I have rejected from very early on in my career is the backward-looking way. This method involves looking at past returns and correlations, but given that the starting point is different, the outcome will be different too. Furthermore, all of these models rely on correlation assumptions and a high degree of stability in correlation between assets. But history shows that correlations are the exact opposite: they are very unstable. In other words, the way that each and every asset class behaves in relation to the others is not stable over time.
At Julius Baer, we prefer to take a forward-looking perspective. It starts with the secular outlook, where we carve out the key structural trends and forces that are at work in the economy and the markets. We then use our capital market assumption including forward-looking expected returns for asset classes, and we optimise the assets as a function of that forward-looking perspective.
Portfolio building
Once you have decided on your asset class breakdown, you need to decide how you are going to implement each and every asset class that makes up your portfolio. Will you pick a fund? Will you pick an ETF? Will you buy direct securities? Will you invest passively or actively? For both active and passive investing, you have to pick the right instrument and this is about making sense of the whole portfolio, because the sum of the parts is far more important than each and every individual part.
The investment horizon
The next consideration is the time horizon of your investments. If your strategic allocation is well calibrated with regard to your risk tolerance, the longer the time horizon, the better. This is in every investing textbook. But the matter is – life is uncertain and as Keynes said, in the long run we are all dead. The paradox is that the longer you are patient, the less uncertain investing becomes. Of course, you cannot tell everyone that they need to wait for 20 years; commercially it is simply not viable. Only a pension fund with extremely clear liabilities can do that. Therefore, I think that a four- to seven-year horizon is a reasonable, pragmatic timeframe for a private investor.
Portfolio adjustments
Within that window, though, you might be tempted to adjust your portfolio. Most of the time it is important to stay the course and stick to your strategy. Whether you should act and do something different will be a function of what happened in the markets. I always say that an investment manager can only be as good as the opportunities allow him to be. There will often be opportunities along the way to either take some profits and reinvest some capital in other asset classes or to rebalance or buy more of what you already own but it is really the markets that provide these opportunities over time. The volatility regime will also be very important. There will be times when volatility will be low and the dispersion of asset return is rather low, so why would you move? But there will also be times when volatility is higher, providing opportunities to trade.
Rebalancing
Rebalancing has the merit of bringing discipline. You could argue that someone who is very young, with a very long time horizon could start with half equities, half bonds. Eventually over time, the equities would outperform the bonds, so the share of equities will increase. But the circumstances of individuals will change over their lifetime; their liabilities, their family, their personal situation will change, so no rebalancing is not an option either.
In short, you should fundamentally revisit your strategic allocation once a year. Again, I cannot emphasise enough how important the secular outlook is, as you need to understand the structural trends and then position yourself accordingly. If you rebalance, the frequency of the rebalancing should be at a maximum once a year, and not at the end of the year. Rather, it should be on June 30, the way that endowment funds typically practice rebalancing.
Asset allocation takeaways
The most important thing to remember is that you need to calibrate your asset allocation as a function of your risk profile. It is not a scientific calibration and emotions will play a role, but you should be able to stick to your asset allocation no matter what happens in the market.
The second point is that you should not spend too much time predicting the future. You need to diversify precisely because the future is unknown and is very uncertain, so you want to spread your investment reasonably. You don’t need to overly diversify, but you want to spread your investment over different types of risk premia and different types of asset classes. Then stick to it. Don’t over react to the news. Look at your portfolio a maximum of once per quarter – that is more than enough. Every once in a while, there will be an opportunity in the market, such as a big shock, and then you should really take advantage of it. But most of the time, you should start from the principle that you don’t know what happens tomorrow.
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