“Don’t Put All Your Eggs in One Basket”. It means don’t risk everything all at once. If you had a certain number of “eggs”, it would be safest to put those eggs in different “baskets” and not “put them all in one basket”. To “put all your eggs in one basket” would be to risk losing all of your “eggs” in case you drop that one “basket”.
Even if you are new to investing, this old adage explain you the most fundamental principles of sound investing. If that makes sense, you’ve got a great start on understanding asset allocation and diversification.
Studies have shown that proper asset allocation is more important to long-term returns than specific investment choices or market timing. Asset allocation means diversifying your money among different types of investment categories, such as stocks, bonds, and cash. The goal is to help reduce risk and enhance returns.
The process of determining asset mix in your portfolio is a personal choice. The asset allocation that works best for you at any given point in your life will depend largely on your time horizon and your ability to tolerate risk.
Time Horizon – Your time horizon is the expected number of months, years, or decades you will be investing to achieve a particular financial goal. An investor with a longer time horizon may feel more comfortable taking on a riskier, or more volatile, investment because he or she can wait out slow economic cycles and the inevitable ups and downs of our markets. By contrast, an investor saving up for a teenager’s college education would likely take on less risk because he or she has a shorter time horizon.
Risk Tolerance – Risk tolerance is your ability and willingness to lose some or all of your original investment in exchange for greater potential returns. An aggressive investor, or one with a high-risk tolerance, is more likely to risk losing money in order to get better results. A conservative investor, or one with a low-risk tolerance, tends to favour investments that will preserve his or her original investment. Check your risk tolerance here.
The two most commonly used terms when referring to asset allocation are strategic and tactical asset allocation.
Strategic (or neutral) asset allocation refers to the neutral asset allocation that aims to achieve the investor’s long-term investment objectives. It is based on the longer-term risk and return outlook for the asset classes.
Tactical (or dynamic) asset allocation aims to take advantage of perceived inefficiencies in asset pricing in the short-term. The deviation from the Strategic asset allocation is done with the aim to enhance returns in the shorter term. The decision rule that defines how the Tactical asset allocation is implemented could be different for each investor.
Every investor or portfolio has a Strategic asset allocation that is used to model the returns that the investor is likely to achieve in the long-term.
Based on data since 1997 and Risk Tolerance level, we have created five model strategic asset allocations using reverse optimization process through gradient quadratic programming method of Nobel laureate William F. Sharpe.
- Conservative Asset Allocation – Equity: 1.6%, Debt: 79.1%, cash: 19.3%
- Moderately Conservative Asset Allocation – Equity: 6.4%, Debt: 93.6%, cash: 0.00%
- Moderate Asset Allocation – Equity: 23.9%, Debt: 76.1%, cash: 0.00%
- Moderately Aggressive Asset Allocation – Equity: 33.9%, Debt: 66.1%, cash: 0.00%
- Aggressive Asset Allocation – Equity: 44.0%, Debt: 56.0%, cash: 0.00%
You can check these models here.
We use another reverse optimization model – Black Litterman model to arrive at the tactical asset allocation. Though Nobel laureate Harry Markowitz’s mean-variance optimization is one of the cornerstones of modern portfolio theory and has become the dominant asset allocation model. However,
- Mean-variance optimization is very sensitive to the estimates of returns, standard deviations, and correlations. Of these three inputs, returns are by far the most important and, unfortunately, the least stable.
- Input sensitivity indicates that the model’s output (the asset allocations) changes significantly due to small changes in the input (the capital market assumptions). Input sensitivity causes mean-variance optimization to lead to highly concentrated asset allocations.
The Black-Litterman model was created by Fischer Black and Robert Litterman. The Black-Litterman model enables investors to combine their unique views regarding the performance of various assets with CAPM market equilibrium returns in a manner that results in intuitive, diversified portfolios. More specifically, the Black-Litterman Model combine the subjective views of an investor regarding the expected returns of one or more assets with the CAPM market equilibrium expected returns (the prior distribution) to form a new, mixed estimate of expected returns (the posterior distribution).
The CAPM market equilibrium returns are calculated using the reverse optimization technique described by Sharpe. You can see the tactical asset allocation area graph based on risk tolerance here.
Our five-step asset allocation process:
- Establish a Strategic (long term) allocation
- You need to know the Risk Tolerance Score
- And to align with one of the five Market Portfolios based on risk tolerance
- Market portfolios are your reference point for monitoring deviation from your risk profile.
- Shift your asset allocation away from strategic allocation only when there are “valuation” opportunities:
- When one asset class is extremely undervalued relative to competing asset classes
- When we can make high-confidence assessments of the impact of cyclical factors that might enhance or detract from such opportunities
- Analyse and choose actively managed mutual funds, and in some cases Exchange Traded Funds (ETF), to implement your asset allocation. Use the Fund Screener to select the top-rated Schemes. Choosing more schemes leads to greater diversification, but avoid unnecessary diversification. Eliminate any schemes you do not want to own for any reason; however, you should keep at least 20 schemes in an effort to properly manage risk.
- Hold for at least One year – For better Tax Efficiency
- In our opinion, it is a better idea to keep your investment for approximately one year. This to maximize your after-tax returns; therefore, holds the gains for more than a year to become long-term, and book any losses before the one year holding period is reached.
- Go Back to Step 1
- Once you have sold any gains and any losses, select and purchase a new portfolio by following step 1 to 3.
The greatest asset allocation strategy won’t work if you can’t control your behaviour. That’s one of the biggest reasons keeping your disciplined investment strategy as simple as possible. The truth, that long-term investing after fees and taxes beats active wealth management, is hard to accept.
It’s much easier to control how you behave with a simple strategy since you won’t be tempted to jump in and out of the market or find the next best investment trend. And basing your decisions on complex and structured products won’t keep you in your plan when turmoil hits.
- Reverse Optimization aa_gradient_tgblog
- Black-Litterman Model aa_bl_tgblog
Acknowledgment (For idea, content, formula and calculation)
- http://www.blacklitterman.org and the reading list published on the website.
- Macro-Investment Analysis by William F. Sharpe
Financial Modeling by Simon Beninga