Asset Allocation Defined: Achieving a desired risk and return configuration by investing funds across different types of asset categories.
1. The Goal of Asset Allocation: To reduce uncertainty (minimize volatility risk) at the expense of a small portion of returns.
Alternatively, it can be said: To enhance returns without increasing risk.
What does it mean to achieve the desired risk return through asset allocation?
Stocks offer the highest returns over the long term. Generally, decent investment results can be achieved simply by buying and holding (Buy & Hold) stocks, or investing regularly and consistently.
However, stocks trend upward over the long term experiencing significant volatility. Thus, in the investment process, the timing of entry and exit can greatly impact the outcome. Even with an extended timeline, reasonable returns are possible, but the interim process might involve substantial psychological stress. Imagine the feeling of watching a retirement fund of 5 a year.
But if investing in assets with lower volatility, such as bonds, although the fluctuations are relatively stable and not drastic, the returns are much lower. You might be dissatisfied with the returns, and it’s challenging to predict whether holding a single asset (even bonds) might suddenly encounter a black swan event causing significant loss.
Hence, it was discovered that holding different types of assets (stocks, bonds) simultaneously could significantly reduce volatility without decreasing the rate of return too much.
The process of selecting and allocating proportions of different asset types is known as “Asset Allocation.”
2. The Principle of Asset Allocation: Trends of Two assets having “negative correlation” or “no correlation”.
If stocks fall and bonds rise, or vice versa, this relationship is known as a “negative correlation.”
This negative correlation is not a precise statistical correlation coefficient but a general phenomenon. In asset allocation, we do not require the trends to be opposite or utterly unrelated. It suffices if “other assets remain unaffected when one asset experiences a significant drop,” achieving the goal of reducing volatility.
Besides stocks, other assets exhibit similar patterns. For example, the trends of gold and other precious metals are not closely related to the stock and bond markets, meaning their rises and falls are unrelated and can be considered “no correlation,” indicating very low relatedness.
The performance of Real Estate Investment Trusts (REITs) is somewhat similar to stocks but not identical.
Thus, when funds are distributed across different asset categories, even if a single asset (e.g., stocks) experiences a significant drop, other assets may be less affected or even rise, ultimately leading to reduced volatility. However, the long-term rate of return may not decrease too much.
In practice, most different asset classes are configured using assets with low correlation, and besides stocks and bonds, few have negative correlation characteristics.
Additionally, since the volatility of stocks is several times that of bonds, unless bonds have a high allocation proportion or use more volatile long-term bonds, their ability to reduce volatility is limited. However, this is usually sufficient for most investors.
3. The Asset’s Returns Must Trend Upwards in the Long Term.
Assets that can generate positive returns over the long term must be chosen for allocation.
Stocks, bonds, and real estate (REITs) are unquestionable. More controversial are commodity assets (Commodities), including gold, oil, precious metals, agricultural products, etc. The price trends of these assets are more influenced by supply and demand, and they partly serve as inflation hedges. In the long term, their returns are relatively lower than other asset classes, and they are more volatile.
However, as their trends are mostly unrelated to most stocks and bonds, they are effective in reducing overall volatility. They are not essential for asset allocation, but many renowned asset managers (like Yale University’s endowment) allocate a portion to commodity assets.
4. The Focus of Asset Allocation is “Reducing Volatility,” Not “Pursuing High Returns.”
Many people with limited funds seek high returns but fear risks, wondering if it’s possible to have high returns with low risk.
This is not achievable. Asset allocation is about sacrificing some rate of return (lower than investing solely in stocks) to significantly reduce uncertainty.
When your investment horizon is long, and you don’t have a lot of funds, pursuing high returns through long-term stock market investment might be the best. If you can disregard the interim volatility, asset allocation might not be necessary.
Conversely, if you are easily affected by volatility, have a shorter investment period, or are investing a large amount, then asset allocation becomes crucial. It can significantly reduce volatility issues, but the focus should not be on high returns but rather on reducing volatility.
5. Long-Term Investment is Still Needed to Achieve High Certainty Results.
When holding highly volatile assets for a short period, there’s a risk of buying high and selling low.
After asset allocation, volatility decreases, so there’s less fear of buying at the peak for short-term investments.
However, volatility cannot be eliminated. Extending the investment period increases certainty, and a minimum of 5 years or longer is recommended for more certain outcomes.
This leads to a contradiction: If one can hold long-term, should the interim volatility be disregarded?
For example, if holding stocks long-term yields better returns, is asset allocation unnecessary?
It depends on one’s psychological resilience and the size of their funds. If the funds are substantial and volatility is a concern, then it’s even more important to reduce volatility risk through asset allocation.
Conversely, those who are less concerned about the process and have a higher risk tolerance can hold a higher proportion of stocks.
6. Understanding Your Investments.
If you create a certain asset allocation and ask me, “Is this allocation ratio appropriate?”
My first question would be, “Do you understand your investment?”
You might hope for a standard answer on how to operate best, but there is no standard answer.
Firstly, we only know the past and can only speculate, not predict the future. Secondly, any good investment might be abandoned halfway due to volatility if you don’t fully understand its characteristics.
I believe that the characteristics of assets, when extended over time, become quite apparent, including their volatility, cyclical nature, and long-term rate of return.
Only when you know what you are buying can you hold it for the long term.