There is significant evidence available that asset allocation is extremely difficult to get right. Indeed it is generally accepted that investors get major market movements wrong, exhibiting a tendency to buy high and sell low. To set ourselves up to avoid making this mistake it is useful to explore why this might be the case.
Let us use stock markets as an example. Equity prices will only be low when the background news is bad. In late 2008/early 2009 when equity markets troughed, the news was absolutely terrible.
Investors were worried that the global economy was about to head into a severe recession, with the potential to become a second Great Depression. Company earnings were being decimated as economic activity dried up, meaning that it was all but impossible to put a realistic valuation on markets. It was difficult to know whether companies would even survive in this severe environment.
Fear of buying when prices are low
It is challenging now to recall just how bad things felt at the time, but it is not exaggerating to say that an investor who took an extreme overweight in equities at that time could be considered reckless. And if that overweight position had gone wrong, questions of negligence could even have been raised.
In addition to this understandable reluctance to be seen as irresponsible, there are likely to be other factors at work reinforcing the inability to buy the lows. First, there will be losses in the portfolio as a result of the previous falls in price. In the case of an individual, this will make him feel less financially secure and therefore less inclined to take on more risk. For an insurance company, the situation is likely to be even worse. Solvency will be in poor shape after market declines, encouraging a reduction in risk assets. And senior management will hardly be in the mood to take on more investment risk in the face of recent losses.
Finally there is scale of action needed to take an overweight equity position after market declines. Let’s say our portfolio starts at 50% equities and 50% bonds and the equities then fall 20% while the bonds remain unchanged.
Just as a result of the equity market move, the portfolio is now 44.4% equities, 55.6% bonds (the 50 in equities falls to 40, while the total portfolio falls to 90, so the equity weighting is now 40/90). So an investor who wants to take advantage of the fall in price to take a modest, 2%, overweight position in equities is looking at selling 7.6% of the portfolio from nice safe bonds to buy an asset that has just fallen 20% in value. It is probably fair to say that the majority of risk committees would raise objections to such a suggestion.
Only buying when the market is less volatile
So it is difficult to buy at the lows, and markets often move off the lows sharply enough to make investors feel that prices have risen too fast, making them reluctant to chase the market. There is evidence that investors were extremely slow to come back to equities after prices started rising in 2009, net flows to equity funds did not really turn clearly positive until 2014.
But after a number of years of equity gains, in recent years with very little volatility, the pressure to get in builds. The situation is exacerbated by the very low yields available on cash and bonds. Competitors may be taking more equity exposure and gaining an advantage as a result and the balance sheet is likely to be in good shape and able to tolerate more investment risk.
The question becomes why equity exposure is so low given the attractive returns available and the low returns being earned on cash and bonds? And once enough people have come back to stock markets, they are nicely set up to disappoint and remind us of how risky they can be once again.
Understanding risk tolerance
With such understandable reasons why it is difficult to get asset allocation decisions right, particularly when faced with balance sheet pressures, the question becomes how to avoid falling into the trap, instead setting ourselves up to take advantage of lower prices, rather than being forced to sell at the lows.
Understanding risk tolerance clearly is a key factor. Although risk models have a part to play, it is only by thinking through worst case scenarios and our likely reaction to them that we can hope to prevent being forced to act at the wrong times. If our equity holdings fell by 20%, what would our reaction be? What about a 50% fall? Setting up portfolios using a worst case scenario type of thinking is likely to lead to a more risk averse portfolio overall, but will help minimise the chances of being forced sellers at the worst possible times.
Keep a long term view
Keeping a clear view on long term expected asset class returns can also help to encourage the right asset allocation thinking.
In order to make long term return forecasts, a number of inputs have to be considered, including, for example, the path of interest rates and yields, corporate earnings, default rates etc. If these assumptions are made on a long time horizon (say 10 years) then they are unlikely to change dramatically on a cyclical basis.
If underlying assumptions do not change, then any change in market levels will change the future expected return in the opposite direction. So at market lows, assets will offer more attractive prospective returns and encourage us to take advantage of the lower prices by buying more, rather than selling out because the news is bad.
In 2008 the background was so bad that it was tempting to feel that long term assumptions, with respect to corporate earnings for example, would need to be revised. But in fact a few years later, we can see that the path of corporate earnings has not been very greatly affected by the global financial crisis.
Portfolio drift and rebalance
One other element of asset allocation that is worth being conscious of is portfolio drift and whether to rebalance or not.
As demonstrated earlier, market movement can significantly change the asset allocation of a portfolio, and there are a number of ways to react to this. Portfolios can be rebalanced on a calendar basis (each month, each quarter), or based on the change in asset allocation from target (+/-1 or 2%), or using discretion and making a conscious decision whether to rebalance or not.
In a market where prices are exhibiting an extended trend, it is preferable to let asset allocation “drift”, whereas if markets are more mean reverting, it is advantageous to rebalance. Thinking in this way about the expected market environment can be a useful input to the asset allocation decision.
Awareness and understanding
Asset allocation is a notoriously difficult thing to get right, both for individuals and institutional investors. Those with solvency or balance sheet pressures face particular challenges in volatile markets.
Being aware of the dangers, carefully assessing risk tolerance, understanding portfolio dynamics and keeping in mind return forecasts which we are confident in, can all help to set investors up to make, not perfect, but better asset allocations choices over the long term.
Mr Denis Gould is CIO, Hong Kong, Multi Asset and Wealth at HSBC Global Asset Management.