Diversification of a portfolio is one subject which causes major differences of opinion. At one extreme, there is the entrepreneur who invests all resources in his or her business. Such a single-minded focus could turn an entrepreneur into a Bill Gates. But it could also lead to bankruptcy.
Most people don't take it to that extreme. There is general agreement that some amount of portfolio diversification is useful. But there are big differences of opinions about how much diversification there should be.
There are also arguments for and against wide versus narrow asset-allocation. Some investors want a narrow and focused stock portfolio. Others want a broadly diversified stock portfolio. Some investors say a narrow stock portfolio allied to some debt assets is good enough. Others want a carefully balanced combination of diversified stocks, debt, real estate, precious metals and commodity exposure as well.
Diversification is one thing, rebalancing is another. Portfolio management and asset-allocation are ongoing processes. The experts say that a portfolio should be rebalanced every so often to maintain a desirable ratio of assets. If one asset class has seen disproportionate gains, profits should be booked there and some cash be switched to other assets where the investor is underweight. Again, there are disagreements about what asset allocation ratios are optimal and how often rebalancing should be done.
Most financial planners factor in age and risk appetite when they calculate a desirable ratio of assets. A young person is usually advised to keep a high ratio of the overall portfolio in equity, while an elderly person is advised to keep a larger proportion in debt.
What happens to an elderly person whose retirement comes in the middle of a long bear market? Should such a person liquidate the equity portfolio and book losses? Stock markets often see long periods of bearishness. Somebody hitting retirement during such a phase may be well-advised to "break the financial plan" by waiting for a recovery in share values.
Creeping inflation also erodes the value of a debt portfolio. This can drive an elderly person into penury. This has happened to millions all over the world. One of the downsides of better healthcare and nutrition is that life expectancy increases. In India for example, life expectancy improved from 49 years in 1970 to 62 in 2000 to 67 in 2010. An extra 10 years of life means debt assets must be adjusted for that much more in terms of inflation.
If there is an unexpectedly long period when one asset class does not perform, an age-linked strategy could be disastrous. There have been long periods when debt and equity have both been losers. For example, in Japan during 1990-2009, the stock index saw net losses and interest rates were near-zero.
All mechanical portfolio diversification, asset allocation and rebalancing systems have one useful hidden agenda. These aim to impose mechanical processes, which reduces the chances of things being messed up due to dangerous behavioural biases. Unfortunately, individuals must often use judgment anyhow and that brings biases back into play.
Right now, mechanical asset allocation methods would suggest that investors cut back on their equity exposure as part of a rebalancing exercise. Equity has shot up in calendar 2014 and it may be time for other assets to outperform. However, this brings us to another question, the timeframe of investment. How long are you prepared to hold your equity portfolio? If you are looking at the very long term, you should not rebalance.
Most people don't take it to that extreme. There is general agreement that some amount of portfolio diversification is useful. But there are big differences of opinions about how much diversification there should be.
There are also arguments for and against wide versus narrow asset-allocation. Some investors want a narrow and focused stock portfolio. Others want a broadly diversified stock portfolio. Some investors say a narrow stock portfolio allied to some debt assets is good enough. Others want a carefully balanced combination of diversified stocks, debt, real estate, precious metals and commodity exposure as well.
Diversification is one thing, rebalancing is another. Portfolio management and asset-allocation are ongoing processes. The experts say that a portfolio should be rebalanced every so often to maintain a desirable ratio of assets. If one asset class has seen disproportionate gains, profits should be booked there and some cash be switched to other assets where the investor is underweight. Again, there are disagreements about what asset allocation ratios are optimal and how often rebalancing should be done.
Most financial planners factor in age and risk appetite when they calculate a desirable ratio of assets. A young person is usually advised to keep a high ratio of the overall portfolio in equity, while an elderly person is advised to keep a larger proportion in debt.
What happens to an elderly person whose retirement comes in the middle of a long bear market? Should such a person liquidate the equity portfolio and book losses? Stock markets often see long periods of bearishness. Somebody hitting retirement during such a phase may be well-advised to "break the financial plan" by waiting for a recovery in share values.
Creeping inflation also erodes the value of a debt portfolio. This can drive an elderly person into penury. This has happened to millions all over the world. One of the downsides of better healthcare and nutrition is that life expectancy increases. In India for example, life expectancy improved from 49 years in 1970 to 62 in 2000 to 67 in 2010. An extra 10 years of life means debt assets must be adjusted for that much more in terms of inflation.
If there is an unexpectedly long period when one asset class does not perform, an age-linked strategy could be disastrous. There have been long periods when debt and equity have both been losers. For example, in Japan during 1990-2009, the stock index saw net losses and interest rates were near-zero.
All mechanical portfolio diversification, asset allocation and rebalancing systems have one useful hidden agenda. These aim to impose mechanical processes, which reduces the chances of things being messed up due to dangerous behavioural biases. Unfortunately, individuals must often use judgment anyhow and that brings biases back into play.
Right now, mechanical asset allocation methods would suggest that investors cut back on their equity exposure as part of a rebalancing exercise. Equity has shot up in calendar 2014 and it may be time for other assets to outperform. However, this brings us to another question, the timeframe of investment. How long are you prepared to hold your equity portfolio? If you are looking at the very long term, you should not rebalance.
The author is a technical and equity analyst