Saturday, December 8, 2007

Asset allocation is the key to stable growth

If you're in for super high returns, then I can safely say that you do not need asset allocation. Asset allocation is all about managing risk between asset classes. When you manage risk, returns will also correspondingly go lower.

In general, I would say there are only 4 kinds of asset classes: Cash, Bonds, Equities, and Alternate investments. I've mentioned the few asset classes in my previous post here. There are lots more asset classes some people has come up with, but the reason why I summarize it into these 4 classes is because these 4 classes are not really co-related. That means if equities are down due to a recession or bad market conditions, cash and bonds might rise because most investors are moving towards safer, and less volatile assets.

There are 2 kinds of asset allocation. The macro, and the micro view. Macro view will be the distribution of the 4 asset classes. General rule: The safer your portfolio is, the lesser the returns. For those who can stomach high risks, you can see allocation like 80% equities, 15% bonds, and 5% cash, that might give you 10% per annum compounded. For those who wants to play safe, you can have something like 50% equities, 50% cash, that might give you 5% per annum compounded. It all depends on how much risk you're willing to take.

As we all know, the devil is always in the details. For micro view, it will be more complicated. There are mainly 3 types of asset allocation for the micro view for equities and bonds:
  1. By Country
  2. By Sectors (Not really applicable for bonds)
  3. Combination of the above

Combination is by far the most complicated where you set target allocation on the sector itself, and within that you'll sub-divide it to countries, or vice versa.

Sector allocation is to sub-divide your investments according to the business type. For example, if you have 80% equities, you might sub-divide it like 20% consumer goods, 20% conglomerates, 30% finance, 20% manufacturing, 10% REITs. Most often though, the costs will be high because indexing is usually by country, and not by sectors. However, people has argued that sector allocation is the safest way because different sectors co-relate different due to the different business nature. As you can see, I have put REITs under equities allocation. I do not agree with the books that I should put REITs as a separate class by itself because it is just in essence, a risky Fixed Deposit that gives higher payouts. REITs prices also goes up and down together with the market. Payouts will also depend on the economy, which is in a way related to the market.

Country allocation is by far the most popular. For countries, there are also different methods to go about in it. For example, some like to first sub-divide it into local market, emerging market, and foreign market. So you might get an allocation that is 40% local, 20% emerging, and 40% foreign. After which, you further sub-divide it again to the individual countries. So with 40% foreign market, you might like to divide it into 50% US, 50% Europe, for example. Within that 50% US, there might be big cap companies, mid-cap companies, small-cap companies and REITs. Indexing is the most preferred way for asset allocation by countries.

For Cash allocation, it's more straight forward. There are only a few types. Treasury Bills/Bonds (T-Bills/T-Bonds), Money Market Funds, and Fixed Deposits. Usually, you would like to make sure that your cash allocation is liquid, and which you can draw in short notice. Cash allocation is important because for investments, it's always looking at it for the long term (10,20,30 years). Investors usually try their best not to draw on the portfolio before the compound interest can do its magic. Therefore, the only place where they can draw their cash is from this cash allocation. Some for example might put their 6 months emergency cash in money market funds withdrawable in a few days, and the rest in money market funds and T-Bills.

There is not hard and fast rule for alternate investments, because they are varied, and can range from wine investment, to property investment. I introduced a new entry to it, called job investment. :D

Some might ask... What's all the point for putting a fixed % in all these asset allocation? This is because of the popular quote: "Buy low, Sell High". Let's say your allocation is 50% Singapore, 50% US. US allocation suddenly tanked to 40% due to the subprime crisis, so the allocation became 60% Singapore, 40% US. By shifting 10% of Singapore back to US, you're in essence selling high (Singapore), and buying low (US). That's the whole idea of asset allocation. It tries to bring the emotion out of investing.

For asset allocation, its not recommended to keep monitoring it. Some do it maybe once or twice a year. Furthermore, they do not immediately re-allocate the allocation. For the same example above, let's say the allocation has changed to 55% Singapore, 45% US during your half-yearly review. If your variance buffer is 5%, you will do nothing. Only if it varies for more than 5%, then you will start re-adjusting your allocation. Some though, like to re-allocate whenever something happens to the global economy. It all depends on preference. The point of not looking at it often, is to keep costs low. It's no use getting 10% per annum, but 5% of it will be for expense. It'll be alot of work for nothing.

It's recommended to do a big change to your asset allocation as you grow older. Reason is that as you become older, your risk profile will change. You will have a family, commitments, and wish to leave the rat race. Therefore, some people might gradually shift their allocation. Some might shift from 80% equities, 20% bonds, to maybe 20% equities, 80% cash after maybe hitting 50 years old. Equities are quite volatile and you would not like to retire when the economy is going towards a recession, with 80% equities.

There are lots of books on asset allocation. If you're looking for more details, it'll be best to borrow or buy these books. I'm basically just summarizing what I have read for future reference. :) My "last" post on this retirement planning series will be on how to withdraw from your retirement portfolio. This will in a way relate to asset allocation.

I just hope I have the time to write it. :)

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