Friday, December 10, 2010

Asset Allocation revisited

This whole business of "asset allocation" has been overhyped. As per conventional theory which all financial planners like to quote, "it has been shown that 80% of your return depends on asset allocation (between debt, equity, etc.) and only the balance on individual skill, luck, timing, or whatever".  So you should invest in a disciplined way x% in equity, y% in debt, etc. 


The asset allocation theory is being stretched to say things like "x% in local equity, y% in debt, z% in emerging market equity, a% in commodities" – basically, don't put all your eggs in one basket. But how do you determine those percentages? Don't believe any numbers that are thrown at you from so-called sophisticated financial analysis. Most of the analysis rests on the fundamental premise that the different asset classes have a low or negative correlation. The way asset prices move up and down nowadays, they all move up or down at the same time, thus destroying the fundamental premise itself.



The problem with all such "automatic" algorithms is that they are based on assumptions that are forgotten later - and the rule is blindly followed. There can be no one rule. Investment is opportunism, and strategies will have to keep adapting with changed circumstances.



One more rule "As you grow older invest less in equity, and more in debt. Follow the 100-age rule to decide the percentage you will invest in equity."



The performance of equity markets is tracked by looking at the "index". The Index is just a bunch of selected stocks with assigned weights out of a universe which consists of hundreds of stocks. Hence the performance of the index is no indicator of the performance of any individual scrip, especially a stock that is not part of the index. However, all stocks tend to move along with the index (the beta) apart from moving on their own due to "intrinsic" (alpha) factors. The fact that the movement of the index usually is a good proxy for movement of individual stocks just shows that factors which move the market play a very important role in the performance of your portfolio, apart from your individual scrip.



You are supposed to ignore these dips and rises in the index and keep investing the same percentage in a disciplined way, as per the asset allocation school of thought. They are right in a sense if you consider the fact that most people buy when the markets have already trended up, and sell when it's down. Any non-thinking approach, read disciplined approach, will give better returns than that.


January 2008: 21,000. October 2008: 9000. December 2010: 20,000.


If you had bought at the highs and sold at the lows, you are screwed.  The disciplined approach is better. But with such volatility, can we afford to ignore the market movements?


Take today's levels. Given the macroeconomic factors (of the world economy!) we do not know how money flows will happen. If money is pulled out of India, the markets will fall. If a lot more money comes in, they will rise, but making the situation even more ripe for a steeper fall. I would probably reduce my exposure to equities right now.


No asset allocation theory takes real estate into account. Real estate will throw all your theories off by miles. It needs lumpy sums of money, and probably a loan as well. So in effect, say when you buy your first house, you are invested in real estate more than 100% of your net worth! Then you repay you loan over a period of time, save some more money whether in equity or debt, and then when you buy your next property – you are back to more than 100% in real estate since you have another loan! It does not make sense to keep fixed deposits or debt investments on the one side, and a loan at a higher rate of interest (which it invariably is) on the other. So what asset allocation are we talking about?


Theory urges us to keep more and more money in debt as we grow older. When you are around 50, keep at least half your portfolio in debt. That yields you 8%, and net of tax 6%. Inflation is running at 7% levels – or let's assume what you get just covers inflation. How can you become wealthy following this approach?


Life expectancy has increased. Job expectancy has decreased. Let us say you stop working at 55, due to factors voluntary or involuntary, and you have 70% of your money in debt. You are going to live till 100 (God bless you!) – pray, how are you going to manage?


In the US currently, debt is yielding a return of zero point zero something percent. So they are drawing down on their principal to meet living expenses? And their life expectancy is high…


Then what do we need to do?  Which investment gives us  very good potential for upside while minimizing the downside? Real estate, as in land. Buy small plots in places which are going to see population growth or development. It could be suburbs of large cities or in tier 2 towns about 5 to 8 km from the city centre – in other words, the periphery where development has not yet caught up but will catch up soon. At worst, you will get back your principal and inflation over the next ten years. At best, if you choose well, the upside is, Inshallah, unlimited.


Choose small plots within developments where "conversion" has just happened, where the builder has bought the land very cheaply on a "per acre" basis, converted it, laid out the basic amenities, and sold it to you at a good premium. Let us not grudge him that premium since buying land by the acre and taking care of it is not within our range of capabilities. When it is part of a "development" the security aspect is also taken care of.


Once you buy that land, forget about it. Don't forget to pay the annual property tax though.


When you retire, sell a couple of these plots, and use the money to build on a couple of others, and rent them out for a steady income stream.


If you have identified some good companies which have great growth potential, buy equity directly in those. That's for individual scrips.  For the broad market, when the markets are at a low (who knows what is low– let's say when you think so) buy index etf's.


Borrow to the extent that income streams, including rentals, can support, especially to buy real estate. There is always the threat of hyper-inflation all over the world, given the way governments are running the printing presses. If that happens, it is better to be a net borrower rather than a net lender. It is also good to have your money in "real" assets like real estate and gold/silver.


That reminds me – don't forget to put some money aside in gold and silver!


(What I have said here is not conventional theory, and it is not something everyone will agree with. I welcome your views, reactions, rejoinders, denouncements… )



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