How Can You Determine The Optimal Asset Allocation For Your Investment Portfolio?

Investing

How Can You Determine The Optimal Asset Allocation For Your Investment Portfolio?

Diversification is common in all major asset allocation strategies. It allows investors to reduce investment portfolio risk.

Published on 13 October 2017

Diversification is the common denominator between all major asset allocation strategies. In fact, it could well be the only “free lunch” in finance because it allows investors to reduce portfolio risk without sacrificing expected returns.

But diversification alone doesn’t solve the optimal asset allocation puzzle.

Over the last 30 years, a blended 60% stocks and 40% bonds allocation has returned 10% per annum, with 50% less risk than an equity-only portfolio. It was rightfully considered the optimal asset allocation for moderate risk portfolios. Equity and fixed income have generated healthy returns that have been negatively correlated during periods of market stress. But this asset allocation’s expected risk-adjusted return has greatly diminished as bonds can no longer offer the same insurance protection since interest rates have come down and equity valuations have ballooned.

Seeking to improve upon the traditional 60/40 allocation, some US university endowment funds (eg. Harvard and Yale) have expanded their level of diversification. In the “endowment model”, equity and bond exposures are significantly reduced to give room to other asset classes, such as private equity, real estate, commodities, and absolute return strategies. Unlike the 60/40 allocation, emulating this model has proven rather difficult, short of big sums, in-house investment professionals, and a long investment horizon.

Sylvain Baude, Chief Investment Officer, Oclaner Asset Management

Sylvain Baude, Chief Investment Officer, Oclaner Asset Management

More recently, automated investment platforms, also known as robo-advisors, have emerged as a cheap and systematic tool to devise optimal asset allocations.

Regardless of the strategy, it is imperative to account for investors’ tendency to behave irrationally when confronted to unexpected events. Behavioral economist Richard Thaler, 2017 Nobel laureate, said it best: “In order to do good economics, you have to keep in mind that people are human”.

In practice, we found that a vast majority of investors are inclined to drastically modify their asset allocation after experiencing a drawdown ranging between -10% to -15%. This behavioral bias consisting of buying high (euphoria) and selling low (panicking), was well described in Daniel Kahneman’s book Thinking, Fast and Slow.  In our experience, this behavior is the very reason why many investors are left with disappointing investment performance over a full market cycle.

After nearly ten years of massive liquidity injections by central banks that led to one of the longest bull markets, the astute investor should neither extrapolate future asset class performance nor risk based on recent past.

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