Asset Allocation: What lies beneath

Over the past year, many planners have discovered that portfolios they had constructed for their clients were too aggressive for a market downturn.

Sadly but inevitably, this occurs in every market cycle. No doubt many thoughtful planners are pondering how to design more robust investment portfolios going forward.

An important step in maximisingb long-term return is to avoid substantial losses in the meantime.

A 10 per cent per annum return for a decade will produce a better return than 14 per cent per annum for nine years followed by a 25 percent loss (or 19 per cent per annum for nine years followed by a 50 percent loss).

Thus, for a portfolio to run the risk of a 25 per cent downturn is tout long-term outcomes at risk. In fact, if managed badly, one major downturn can destroy a client’s lifetime financial security.It can also destroy the business a planner has built over a working lifetime.

It is common for an investment process to begin by determining the maximum and minimum exposure ranges for each asset class and identifying benchmark levels. Portfolios are based on these benchmarks,but are varied within the ranges from time to time, depending on the adviser’s view of the market or the perceived risk tolerance of the client.

Many portfolios designed this way have been badly damaged over the past year. With the reality that markets can fall steeply staring us in the face it is surely apparent that, to be robust, any strategy must include controls to limit losses. At times, this is the most important question of all about portfolio construction.

There must be some level floss where clients’ confidence,and financial security, is fundamentally shaken, and where planner shave to acknowledge that their advice has not worked well. What percentage of decline in clients’ asset values is too much?Some planners will have been living through a real life experiment in understanding this question over the past year.

Purely for illustration purposes, let’s assume that clients’ tolerance for a decline in their net worth begins to stretch at around 15 per cent. How might a portfolio be constructed so that, even under extreme conditions, it wouldn’t fall by 15per cent?

Let’s simplistically assume that portfolios consist of growth assets (property and shares) and defensive assets (cash, bonds, and soon, assumed to produce 6 per cent interest). Further, let’s assume that a retiree draws out 5 per cent of a portfolio each year, to support their cost of living.

Now, we need to estimate what‘worst case’ decline could be expected from growth assets.

For illustrative purposes,let’s assume a possible 25 percent fall in growth asset values (while not forgetting that last year has been worse than this).

As Table 1 shows, if you allow for the possibility of a downturn ingrowth assets of 25 per cent, the maximum exposure you can have to growth assets without risk of breaching a 15 per cent portfolio loss limit would be 51 per cent.

Limiting property and equity exposure to half of portfolios would requite a departure from many advisers’ traditional conceptions of a balanced fund. I am not actually advocating it as a ceiling as there are other factors to be taken into account in determining a sound asset mix, as discussed below.

However, it is useful to recognise that, above this, one has to accept the potential for greater downside.

There is a widespread view that portfolios should be tailored to clients’ risk profiles.

One of the key elements in thetheory of risk profiling is the viewthat some clients have a high tolerance for risk, and will not beperturbed by declines in asset values. Planners will now be in aperfect position to assess how well this theory has worked.

Have those clients who wereassessed with a high tolerance to riskremained undisturbed by the losses in their portfolio?

Experience shows that some ofthose investors who might have describedthemselves as ‘high risk’ turn to water when thereality of a market slump hits.

In truth, the people who electa ‘high risk/highreturn’ strategy are thinking about the high return, muchmore than the risk.

If you have found this, itwould be useful to review how you assessrisk tolerance or, better in my view, simply assume that the vastmajority of people do not like to lose money.

Indeed, when they findthemselves reporting large negative returns to clients, many planners discover that their own tolerance for volatility is less than they had imagined.

I once led a discussion of experienced planners on the subject of how our clients measure the success of their portfolios.

It was widely agreed that the criteria changes with market conditions.When markets fall we are measured on an absolute scale (‘Have I lost money?’) or against what could have been earned by money in the bank.

When conditions are healthy, we are measured against the published returns from balanced funds. There is also the ‘golfing mates’ test, that is, how have they compared with the experience of their friends (or at least the claimed experience of their friends).

No strategy can always beat a benchmark that changes from absolute to relative. This is just one of the challenges planners have to live with.

However, it is essential that we set realistic expectations for clients, as we must expect to be judged against what we suggested we could do. It is a trap for young players, during rising markets, to slip into accepting credit for healthy portfolio returns —attributing it to good fund or stock selection, rather than acknowledging that most of the return was just a function of the market. The problem is that, if we accept credit for strong returns, itis hard to deny credit for any subsequent losses.

There is an old investmentcliche that asset allocation is the largestcontributor to returns, which the past 12 months has reconfirmed. TheAll Ordinaries Index and the REIT Index have fallen heavily, and it wasextraordinarily difficult to gain immunity from this by individualstock or fund selection. Consequently, having a sense of when the market is overvalued can be vitally important in protecting clients.

Proportion of portfolio 49.0% 51.0% 100.0%

Net Value 51.9% 38.3% 90.2%

* 6%interest

**Assuming 'worst case' of 25%loss

Most of the methods used to assess market value, including conventional price/earnings multiples, have a poor track record of predicting future market returns. The flaw with this method is that it takes no account of the volatility (actually trend reversion) of E. It is now widely recognised that corporate earnings will reduce in the current environment. Thus it was false comfort to look at the not extreme stock market PE that prevailed in mid-2007.

As I’ve written before, the only market valuation tools that have a reasonable track record of indicating excessively high (or very cheap) markets incorporate an assumption that markets tend to revert to norms, for example, price to trend E, price to trend dividends, and soon.

Each of these showed markets notably overvalued in 2007.

A robust valuation tool is essential as an input into asset allocation.When markets are excessively overvalued, portfolios can be moved into an asset mix designed to limit downside, as described above. At other times, more aggressive portfolios can be implemented.

If planners have a reasonably reliable sense of when markets are dangerously high, and understand what mix of assets can limit downside at those points, they can implement steps to limit the risk of a severe portfolio shock. This can’t provide a guarantee against a severe setback, but it can materially reduce the odds of one occurring.

Of course, everyone is mindful of managing risk in the middle of slump. The real challenge is to remember it when profits are running strong and risk seems banished from the horizon.