In today’s global investment environment, it is easy to feel overwhelmed with the ever-expanding universe of investment choices. Often, investors will follow market trends as an alternative. But trying to achieve financial goals by pouring all of one’s assets into emerging markets today, telecommunications tomorrow, and Japanese small-cap stocks next week is not a guarantee for achieving a sound financial plan.
It resembles more an evening in a Las Vegas casino on the roulette table than a long term approach to growing and preserving wealth. It’s a risk / reward strategy that can offer a lot of risk for potentially minimal reward. It’s also an unbalanced and uncoordinated approach and a practice that contradicts the theories of diversification and Asset Allocation philosophy.
Why diversify?
Simply put, the reasoning for diversifying a portfolio lies in the fact that no asset class or market performs well at all times. A top performing market one year can fall down the ranks the next year and vice versa with a poor performing market rocketing up on a strong year. For example, the Japanese TOPIX was the best performer in 1999 and the worst in 2000. Diversifying your portfolio can increase the chances of taking advantage of the poorer market performing well and the stronger market retracting.
Diversification is a means of hedging bets in the face of unknowable future market movements. Is this any different an approach to managing risk, than, for example, a company ensuring all its board directors do not travel on the same flight? However, when it comes to investments, applying the same disciplines around risk management are considered ‘complex’ and ‘boring’. Investors are often far more tempted and excited by market timing and stock selection. However this approach is not the key to reaching long term investment goals.
Investors are often tempted to follow market trends or invest large portions, if not all of their investable assets into a single ‘hot’ market. It is a strategy that offers large volume of risk with a low possibility of success but similarly of disappointment. A concentrated portfolio (one where all your investable assets are placed on a limited number of bets) is attractive as it can produce enormous rewards, but, it also has the potential to wipe out a portfolio. We have all taken some of these bets, the question is, what percentage of your portfolio were those bets?
Ultimately, the most important step in the investment process is the first step — how long are you investing for or what is your “time horizon”? This dictates the type of risk that you can take, and your ‘liquidity’ requirements. For example, an investor with short term liquidity needs may want to steer clear of real estate and private equity, and focus more on fixed income and cash equivalent instruments. This process is simply called ‘Asset Allocation’.
The importance of Asset Allocation is well-established within the investment industry. A much quoted study by Gilbert Beebower of SEI (Brinson, Hood and Beebower 1991) concluded that Asset Allocation — not market timing or stock selection — is the primary factor in determining why different portfolios have different return results.
At the root of Asset Allocation theory is the concept of correlation of risk which is a statistical measure of how the returns of two different asset classes move in relation to one another, i.e. given a disaster, would both asset classes go in the same direction, or do they go in different directions. The strength of that relationship is called the correlation between those assets. Hence, if you have a group of assets that are negatively correlated to each other it can help reduce the risk in the portfolio.
For example, typically when equity markets are performing well, bonds tend to be in lesser demand as they are less exciting and do not offer the potential rewards that can be gained from stocks. However, when equity markets are suffering, bonds are usually in stronger demand. Investment correlations are developed by looking at years of statistical market data and this data is used by Asset Managers to build diversified portfolios.
How to asset allocate?
There are several factors that contribute to the ‘right’ asset allocation for any investor such as financial goals, risk tolerance levels and time horizons. So, for example, the investment strategy for an asset pool established to support a couple’s lifestyle over the next five years will be quite different than that of the asset pool intended to serve as a gift to the couple’s grandchildren in a couple of decades. The former investment strategy might aim to create a steady income, while the latter pool may be invested more aggressively with the goal of achieving maximum growth over a longer period.
So the most important step requires properly defining objectives and then building the appropriate asset allocation strategies to support them. The process of defining what an appropriate asset allocation is for every investor should involve defining an investor’s objectives carefully and then aligning these with multiple strategies built using various assets.
The key to asset allocation is diversification among the various asset classes (stocks, bonds, cash, etc.) in accordance with the objectives that have been established. The number and variety of investment choices, or asset classes, keep growing all the time — US equity, international equity, US and foreign fixed income, emerging markets, real estate, hedge funds — the list goes on and on. Each market and each segment within each market can be associated with different characteristics, return potential and risks.
The allocation process can continue through multiple layers. The first level selects the asset classes, the next layer, the approach to managing within that asset class, e.g. do you want to buy blue chip companies (large caps) or small emerging companies (small caps). Are you looking for undervalued stocks or for those that are showing future potential growth ideas? There are so many choices, across so many asset classes across so many different markets hence the need for asset managers (or specialists) to help an investor make these decisions.
One way to diversify a portfolio and implement an Asset Allocation approach is to invest in multi-asset class or ‘asset allocation’ funds which in addition to providing diversification across asset classes can also provide diversification within those asset classes. These funds are designed to offer a range of asset mixes suitable for a range of investment goals and investor profiles.
Local markets
There are a number of arguments against asset allocation that are commonly used by investors. The most commonly used over the last few years has been of local and regional market returns and performance. With local equities and real estate offering huge returns, fewer investors were interested in a balanced and diversified strategy. First we had the local equities rally, the real estate boom, and more recently a boom in regional bond markets. Each of these asset classes had very strong performance followed by a dramatic crash.
The volatility in regional and local markets has been significantly greater relative to more developed equities, real estate and bond markets. Compare the performance of the MSCI Arabian Markets Index with a Balanced Benchmark representing a 50 per cent global equities allocation and 50 per cent global fixed income allocation across a period since the launch of the MSCI Arabian Markets Index in May 2005. If $10,000 was invested on 1 June, 2005 into the MSCI Arabian Markets Index, at the end of 2009 the original $10,000 would have dropped to $7,472.
However, if $10,000 on 1 June 2005 was invested into a globally diversified Balanced Benchmark, at the end of 2009 your investment would have grown to $12,372. initially outperformed peaking at $14,924 on 31st Jan 2006 whilst at the same period the Balanced Benchmark was at $10,957, but once the markets began falling in 2006, the MSCI Arabian Markets Index fell steeply and was not able to recover. Its lowest point was on 28 February 2009 where the original investment amount of $10,000 dropped to $5,109 versus the Balanced Benchmark at $9,185.
It is natural for investors to have a keenness for investing regionally and in their own markets. This is human behaviour, and this is known in the investment industry as the “home bias”. However, the challenge when asset allocating is to not let this emotional home bias dominate the portfolio and expose it to significant risks. This is not something that is specific to the Middle East, it is natural behaviour across the world and one investors need to consciously consider and manage.
Did asset allocation work through the credit crisis?
Critics were quick to announce that Asset Allocation failed when at the peak of the crisis, diversification and Asset Allocation appeared not have made a difference as entire portfolios crumbled with the markets. In 2008, nearly every asset class tumbled downwards in unison defying all theories of correlation. It seemed as though there was not much use in spreading your eggs across different baskets when all the baskets broke. Many investors panicked and sold their portfolios and realised losses fearing further collapse in their portfolio values. Particularly those investors that were leveraged.
However, many of those investors that had a thorough appreciation of the theories, held steady and strong. “Time horizon” the most important step in the asset allocation process was brought to the test. Investors that had soundly evaluated their investment time horizon and their liquidity requirements found they had the ability to hold on to their investments, in fact in many cases were able to top up their portfolios with low valued assets. They remained invested and many found their portfolios capturing the strong and rapid market bounce back.
The first quarter of 2009 was driven by faltering equity markets and plummeting fixed-income prices. Then, as has happened in the past, an impressive snapback occurred that caught many investors off-guard on the sidelines holding large cash positions. This led to a rush into risky assets of all types, and for those who were able to stomach the volatility, the ending was euphoric.
Conclusion: achieving long term goals
The global market downturn has reinforced the benefits of a long-term strategy, where such a strategy is appropriate for the investor, and a patient approach. Although diversified portfolios likely experienced losses during the credit crisis and market upheavals that followed, unlike some concentrated portfolios, that loss should not have been as severe.
Investors should remember that if long-term views are maintained and portfolios are properly diversified and structured around risk factors, they likely have taken positive precautions to protect their wealth and ride through the market turbulence. It is the nature of markets to go up and down. Applying the Asset Allocation philosophy and taking a diversified approach can add value by enhancing return potential and reducing risk, increasing the likelihood of investors achieving their goals.
Jahangir Aka is Managing Director at SEI Investments (Middle East)