Investing — Portfolio optimization
Portfolio Allocation Optimization And Why It Matters
Now is a good time to be tactical & strategic with your portfolio
These days, stock markets have reached high valuations. In the meantime, risk and volatility are not expected to weaken given the many uncertainties, such as the coronavirus pandemic or the 2020 US elections, to name but a few. Now more than ever, it is crucial to find some time to build a resilient portfolio, no matter what is ahead of us in the coming months. This is precisely the aim of portfolio allocation optimization.
What Is Asset Allocation And Why It Matters
When it comes to investing, diversify your cash across a number of asset categories is perhaps the best advice to remember. Diversification is quite a good thing as, that way, you are not putting all your eggs in one basket. This is the core purpose of asset allocation.
The difference between success and failure is not which stock you buy or which piece of real estate you buy, it’s asset allocation.
— Tony Robbins
Asset allocation consists of mixing financial assets to build a portfolio. By allocating your wealth, you will spread it between various asset categories (such as stocks, bonds, real estate, gold, cryptocurrencies, etc.) and sub-classes (such as European equities, fintech sector, AAA corporate bonds, logistics real estate, bitcoin, etc.).
Based on your own, specific profile, you will determine the ideal composition your portfolio should adopt. Asset allocation is a crucial step in the process of building a resilient and suitable portfolio. The kind of portfolio that will give you full satisfaction.
As shown above, a defensive/conservative investor profile results in a different portfolio composition than that shaped for a dynamic investor profile :
- For a defensive/conservative profile, risk and investment duration will likely be short as retirement is near or already there. What we want to do here is to reduce risk and safeguard savings. This will typically be allowed by asset classes deemed to be less risky, such as bonds, marketable securities, annuities, or currencies.
- For a growth/aggressive profile, a longer investment horizon allows taking higher risks. As retirement is distant, savings can withstand larger variations without seriousness; they will recover as time passes by. This profile will seek growth and returns, thus favoring riskier asset classes such as equities, real estates, or cryptocurrencies.
Obviously, as potential risk is correlated with a potential return, a dynamic investor should, theoretically, obtain a better return than a defensive investor.
When it is about asset allocation, things go one step further than simple diversification. By allocating your assets, you compose a diversified portfolio based on assets and proportions that will depend on your own, specific profile. Each profile being unique, you will have to carefully define it. The goal, here, is to wisely choose the best-suited allocation.
Oh, and one more thing: asset allocation is not immutable; it is not carved in stone! It can and should be modified regarding how your situation changes over time, or to take advantage of the opportunities when they arrive. We will talk a bit more about this below.
Achieving Your Asset Allocation
Practically speaking, asset allocation is based on two successive steps:
- Strategic allocation
- Tactical allocation
You should have a strategic asset allocation mix that assumes that you don’t know what the future is going to hold.
— Ray Dalio
This first step, strategic allocation, aims to create an allocation key on different asset classes: equities, bonds, cash, etc. Here, you are at the macroscopic, global, and long-term level of your portfolio.
This allocation key will depend on a whole bunch of factors that you first need to define, keeping in mind your specific investor profile. These factors are numerous, here are the main ones:
- Risk tolerance: Do you want to manage your investments with due diligence or do you prefer an aggressive approach? Increasing the risk allows you to increase the equities allocation (more fluctuating and sensitive), at the expense of safer investments (the so-called fixed-income assets, such as bonds).
- Return target: Are you aiming for a low/moderate but regular/stable income, or do you seek a higher but not guaranteed return? In the first case, the bonds will be considered more favorably, while actions will be best suited to the second one. Always remember that risk and return are closely correlated.
- Investment horizon: do you want to invest in the short term (1–3 years) or are you looking for long-term investment (10–15 years or more)? Over the long-term, stocks remain the best-in-class asset for a portfolio. Indeed, even if stocks can suffer from occasional but significant drops (remember this past March), the long-lasting of investability will offset this issue.
- Age: Are you young, near retirement, or maybe are you already enjoying it? Traditionally, young adults can afford more risk than retirees, giving stocks the advantage through a more aggressive, growth-oriented profile (with companies such as Google, Tesla, Roku, Alibaba, etc.). On the other side, conservative retirees will certainly have plenty but precious savings to invest, which will improve the return of fixed-income products. Stocks are not prohibited for retirees, but they must be wisely chosen. A good example is “Dividend Kings”, premium quality stocks whose dividends steadily increase for at least 50 years (such as Altria, Coca-Cola, Lowe’s Companies, etc.).
- Asset sub-classes: Do you want exposure to a particular asset sub-type, industry, or market? Some themes will be more suited to risky profiles (such as biotech stocks, emerging markets, high yield bonds, etc.) and some will be more conservative-friendly (such as government and short-term bonds, low-volatility and dividends stocks, etc.).
- Economic situation: Is the market growing or are we in a recession? Is inflation rising? Business cycle status and economic conditions are a big factor in adjusting the assets mix in your portfolio. There is a strong relationship between the current place of the economy in the business cycle and asset class returns.
For now, we are currently in a transitional phase from a reflation state related to the coronavirus pandemic. Inflation remains low and growth is painfully restarting. Based on the current macroeconomic situation and depending on how far it will improve, strategic allocation advises to overweight cyclical/growth equities. Bond yields remain low as rates are cut and since more cash is continuously injected by central banks, governments risk undermining trust in currencies.
It should therefore be understood that strategic allocation focuses on the major asset classes within the portfolio, namely equities, bonds, cash, and commodities. This composition will be based on many parameters and will change over time.
If a window of opportunity appears, don’t pull down the shade.
— Tom Peters
Once the overall composition of the portfolio has been decided, the next step is tactical allocation. While the strategic allocation was based on a holistic portfolio approach, tactical allocation represents a deeper dive into the chosen assets, having an instant view of the choices available.
For example, a young investor with an aggressive profile in October 2020 could currently determine, through a strategic allocation, that it could be best suited to overweight growth equities from emerging markets, with a low proportion of high-yield bonds and a pinch hint of industrial commodities. The strategic plan is to support economic recovery and be ready for the next expansion phase of the economic cycle.
Unfortunately, times are harsh and uncertainties remain numerous. The plan could be wrong, at least for now. Recession could last longer than expected. But long-term investment horizon will help to pass through these difficulties. In the end, in a few years, things will be better, so will a wisely allocated portfolio. Until then, let’s deal with risk. And as it is correlated to return, risk will pay for this young investor.
Now, it is time to find the right company, the best ETF, or the right commodity depending on what is available on the market. Due to its tactical aspect (in a dynamic sense of the term), the tactical allocation will try to exploit market opportunities in order to improve returns. The young investor will for example be able to take advantage of increased industrial metals needs to temporarily overweight steel and iron exposure, as the economy restarts. And why not riding the digitalization wave through some specialized ETF? According to a report by the Emerging Payments Association, the global COVID-19 pandemic will accelerate the use of contactless payments. This is called being tactical.
When it is time to be tactical, you have to switch from a macro/long-term view to a micro/short-term one, to improve performance. Being tactical makes it possible to overweight or underweight some component of the strategic allocation, which represents the long-term vision of your portfolio.
Asset allocation is one of the fundamental principles in the management of a portfolio. It allows you to build it so that it perfectly matches your investor profile.
You can perform asset allocation by yourself; there are many tools available on the Internet for strategic allocation (here and here, for example). However, remember that in order to overperform and obtain the best returns, a strategic allocation must be accompanied by a tactical allocation. Many asset management companies allow you to build an investment profile fitting to your investor profile while delegating tactical allocation (but pay attention to management fees !).
This way of investing and building your portfolio is by no means compulsory. It also requires having some knowledge and time, both at the start (strategic allocation) and on a daily basis (tactical allocation). But it has the merit of defining something best suited for you. Thus, it should therefore not be neglected!
Raphaël is the founder of Investiforum.fr, a financial website for French-speaking private investors. This article was originally issued on Investiforum, the financial website for French-speaking private investors. Read the original article (in French).
This article is for educational and entertainment purposes only and should not be considered as financial or legal advice. Not all information will be accurate but all the data is sourced. Consult a professional before making any significant financial decisions. This article should not be seen as an incentive to buy or sell any of the securities mentioned therein.