For the average investor, an understanding of asset allocation is more important than reading balance sheets.
Asset allocation, with the associated ideas of diversification, portfolio theory, the capital asset pricing model and the “efficient frontier” are among the most widely-applied concepts. Taken together, they provide a relatively simple set of tools and a framework for portfolio analysis and optimisation.
On paper, it is cut-and-dried. For a given pool of assets, you calculate mean and variance of returns. Compare with risk-free rates and work out correlation matrices for the asset-basket. Fiddling with allocation weights can help one derive the best possible returns available for given measures of risk.
In practice, this is fraught with complications. It’s normal to use historical return, variance and covariance to compute future expected returns and risks. But return, variance and covariance can change sharply.
In addition, it’s assumed that return distributions will be normal. That is often a dangerous approximation. Returns can have very long tails and skew is largely ignored. A big negative skew (caused by low or highly negative returns) means that 99.7 per cent of returns will not be within three standard deviations of the mean as with symmetric normal distributions. It could be four or more standard deviations away.
Even more contentious are theories about the requisite amount of diversification. Some authorities believe that a portfolio of around 20 stocks can eliminate unsystematic risk. Other equally eminent thinkers say that it requires hundreds of stocks.
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To take two extremes in attitude, compare the methods of Warren Buffett and those of Peter Lynch. Buffett is anti-diversification and has generally held narrow portfolios heavy in FMCG and financial holdings. Lynch generally held hundreds of stocks spread across most sectors. Both have striking records of outperforming market indices consistently over decades. Buffett at least, has publicly questioned portfolio theory.
Another problem with diversification is that quite often correlation changes precisely at market turning points. In a big bear market, the vast majority of assets trend down and vice-versa in a big bull market. The diversification edge disappears when you need it as it did when commodities collapsed along with bond prices and stockmarkets in 2008.
Nevertheless the conceptual framework is useful because it provides targets for investors. The theory says that one should look for ways to generate higher returns without taking excessive risks. It also urges you to seek negative correlations between assets because that affords protection.
Portfolio theory can lead investors to find counter-intuitive, efficient holdings where two high-risk and negatively correlated assets are held in combination and magically generate higher returns with lower risks than either of the individual assets.
Above all, asset allocation theory teaches investors not to lose sight of the wood for the trees. Most serious investors focus a large part of their attention on the fundamentals of individual stocks. Most investors know far more about the minutiae of financial ratios than they do about basic asset allocation.
But a portfolio’s risk is more dependent on covariance of assets than on the volatility of an individual asset. An investor should always assess what the effect of plugging a “good” asset into his current holdings is likely to be.
Asset allocation theory, suggests strongly that the key to robust portfolio creation is assigning the right weight to asset classes rather than focussing on individual stocks or assets. Stock picking (and market timing) contributes less than 10 per cent to the return of a well-diversified portfolio.
The maths of asset allocation and portfolio theory is subject to many approximations, and errors can multiply when constructing real portfolios with multiple risky assets. By the time the average investor becomes aware of portfolio theory, he usually holds many risky assets with random weights and sorting that out can be an insurmountable task.
But if the conceptual framework is understood and absorbed early, it leads to better attitude. What sort of risk will an investor bear and what return should he expect for that risk? What weight allocation is likely to fetch that return? These are questions that most people don’t bother to ask before they buy a stock.
There are times when an investor will want to be overweight in a given asset. Awareness of asset allocation theory will ensure that this is done deliberately and not taken to excess. An understanding of asset allocation is probably more useful to the average investor than an ability to read balance sheets.