DANIEL GRIOLI of FuturePlus challenges some recent trends in asset allocation.
In my last article, we considered how the global financial crisis has resulted in a renewed focus on asset allocation. We also considered the importance of valuation and why trying to identify catalysts for changes in valuation can result in missed opportunities. In this article I would like to tackle the notions that shifting asset allocation is a new idea, that minimising volatility reduces risk, and consider why the best way to approach asset allocation is to start with a blank sheet of paper.
Asset allocation: a new idea? For a long time, prudent investors have been shifting their asset allocation to reduce risk and position their portfolio to capitalise on long-term opportunities. In his book, The Intelligent Investor, first published in 1949, Benjamin Graham wrote: “We have suggested as a fundamental guiding rule that the investor should never have less than 25% or more than 75% of his funds in common stocks, with a consequent inverse range of between 75% and 25% in bonds… According to tradition the sound reason for increasing the percentage in common stocks would be the appearance of the ‘bargain price’ levels created in a protracted bear market. Conversely, sound procedure would call for reducing the common-stock component below 50% when in the judgement of the investor the market level has become dangerously high. “These copybook maximums have always been easy to enunciate and always difficult to follow – because they go against that very human nature which produces that excess of bull and bear markets.” Why would a common sense approach to investment such as that described above fall out of favour?As Graham points out, the discipline required to invest this way goes against human nature. Being contrarian – which is what such a strategy requires – only comes naturally to a small minority of people. The rest of us have to fight our inclination to draw comfort from holding opinions that are consistent with those of the majority.
Risk: capital loss or volatility? As considered in my previous article, the popularity of financial theories such as mean variance optimisation, the capital asset pricing model and the efficient market hypothesis influenced many investors to re-define risk. Instead of being permanent loss of capital, risk became the volatility of investment returns. The need to reduce risk by shifting away from overpriced assets towards underpriced assets became less important to investors as they increasingly focused on reducing volatility. In the quote above, Graham highlights the importance of valuation in asset allocation, as it helps to reduce risk by selling assets when prices are high and positioning the portfolio to take advantage of the opportunity of buying assets when prices are low. All else being equal, buying an asset at a cheaper price is less risky, as a lower price equals a greater margin of safety. This is the opposite of how an asset allocation strategy focusing on volatility would behave. Such a strategy would reduce its exposure to assets that have fallen in price, as a rise in volatility usually accompanies a fall in price. The corollary of this is that assets are less volatile when their price has risen, so seeking to minimise volatility has the potential to bias a portfolio’s asset allocation towards expensive assets. This highlights an important point. When it comes to asset allocation, the definition of risk that is used – permanent loss of capital or volatility – may result in very different investment outcomes.
