The Ins and Outs of Asset Allocation

Quiz time: What’s asset allocation?

  1. What finance types talk about – but no one understands
  2. Equations that look Greek ΣμßΩ∂
  3. Short-form for ‘what investors are holding’

The answer: All of the above.

Asset allocation is simple

Asset allocation sounds daunting. In reality, it just describes what you are holding.

If you’ve got everything in a bank deposit account, that’s a 100% allocation to cash. And if you’ve made some investments, bought $100,000 worth of Singapore stocks for example while leaving the rest of your $400,000 in cash, that’s a 20% allocation to Singapore stocks and a 80% allocation to cash.

Everyone has an asset allocation. And getting the numbers is simple arithmetic.

Average can be good

What’s less straight-forward is getting asset allocation to be in tip-top condition. An “efficient” allocation gives the highest return possible for the risk you can take. It divides your money across categories like equities, bonds, commodities and even cash to:

  1. Benefit from top performing asset classes
  2. Reduce the impact of losses from poorer performing asset classes

No market or asset class will always be at the top. Japanese equities for instance, did extremely well in 2005, but fell in 2006, and hit bottom in 2007. It reclaimed top spot in 2012, but not before the roller-coaster of ups and downs from 2008 to 2011. In comparison, a simple “balanced” allocation of 60% world equities and 40% global bonds stays rather consistently around the middle. Clearly, this combination has a better trade-off between returns and risk than a pure Japan equity one.

Why accept being average?

Any wealth manager worth their salt will admit they don’t have 20/20 vision on the future. They use statistics and probabilities to guess which asset classes may do better. This task is complicated by the growing role of central bank or government in attempting to push growth and sometimes skew the natural flow of liquidity. These include the US Federal Reserve’s timetable for rate hikes for instance, or the Bank of Japan’s massive asset purchases. Uncertainty is what makes being average a better strategy than always gunning for the top.

The tough bits: the Greek

Efficient allocations are those that give the best return for any given level of risk. At its simplest, calculations involve calculating standard deviations, correlations, and pro-rating them by how big they are in the portfolio. An efficient portfolio has a better risk-return trade-off than each of its components do, individually. This is called the Modern Portfolio Theory (MPT), introduced in the 1950s by Nobel Prize winner Harry Markowitz. Other finance professors have found loopholes in the arguments. But as the alternative methods are even more complex, the MPT is still widely used – with a few tweaks.

The DBS approach

The team at DBS believes in MPT, but with some tweaks. The Defensive and Conservative portfolios have to meet extra criteria, put in place to protect investors who are unable or choose not to take as much risk.

These are presented as the Strategic Asset Allocation (SAA) model, a set of long-term plans that investors can use to build their portfolios. There is also the Tactical Asset Allocation (TAA) models, tweaks the Chief Investment Office makes based on its view of how asset classes could perform in the next three months. Put another way, the SAA is like a route map for a long journey, and the TAA shows where the “hiding” places and “fast-tracks” may lie.

Are you prepared for the journey?