Thinking Strategically About Asset Allocation: Three Perspectives

Toward the end of April, I wrote a story about one approach to managing asset allocation, the use of a lifecycle approach by some superannuation funds. This strategy sees the asset allocation being changed for an investor based on factors including a person’s age and the balance of a superannuation fund. This is one asset allocation strategy.

There are many approaches used by investors and advisers to determining the important portfolio decisions around asset allocation. As two examples these include the use of questionnaires to determine how comfortable people are with portfolio risk and volatility (the higher the comfort, the greater the exposure to growth assets including shares), or the use of a rule like the ‘rule of 100’, which advocates the percentage portfolio exposure to growth assets like shares being (100 – age). So, a 60-year-old would have a 100 – 60 = 40% exposure to shares. 

I agree with Mark, a Eureka Report reader, who mentioned in the comments to my previous piece that asset allocation strategy is complex. 

In this article I want to provide three ‘perspectives’ that might help you assess how well your current approach to asset allocation is meeting your needs. These perspectives can be used as tests, or ideas, alongside whatever approach you are currently taking.

Perspective 1 – an income planning approach

Perspective 2 – rebalancing a portfolio over time

Perspective 3 – a cash ‘call option’ for a downturn (and a margin of safety)

Perspective 1 – Does an ‘Income Planning’ Approach Work with my Asset Allocation?

Income planning can be used as a perspective to check the effectiveness of a portfolio asset allocation, to consider how well it meets short/medium term cash needs. It focuses on the decision around how much certainty is needed over near-term cash flows. 

For example, a $1 million superannuation pension portfolio might be paying an income of $50,000 per year. An investor might like the certainty of seven years of income set aside in cash/fixed interest assets - in this case $350,000. The remaining $650,000 can be invested in growth assets without the concern about needing to sell assets to meet income needs over the next seven years. Even if this approach is not used as a core asset allocation approach, it is a very useful check - how long can the cash/fixed interest assets in my portfolio meet my drawings, and am I comfortable with this?

As a practical test of this strategy, think about the experience of a retiree during the GFC (global financial crisis) or COVID-19 downturns. Having seven years of income set aside in cash or fixed interest investments allowed them the comfort of riding out the downturn without having to be a forced seller of growth assets at the lower market prices of the time. Keep in mind that as well as the seven years of cash and fixed interest assets they will also be receiving dividends from their growth investments – on the experience of the two most recent Australian downturns this combines to form a fairly attractive buffer against market volatility.

This perspective also has value for people well before retirement – their question is, do I have enough cash/fixed interest assets available to meet short to medium-term needs, and what is my capacity to manage in an emergency, like a period of poor health or unexpected unemployment? Having access to cash and fixed interest investments is important during these times. While some people may be comfortable relying on the liquidity of shares, keep in mind that a significant fall in share market values might coincide with an increased risk of a period of unemployment, making a person without adequate cash/fixed interest ‘buffer’ a forced seller of shares during a downturn.

There is, of course, a balance here too. Investors need to balance their cash/fixed interest investments with the growth assets, including shares, that will better fund their long-term investment needs and counter the negative impacts of inflation – an income planning approach seems to encourage a reasonable balance in growth assets for these longer-term needs.

Perspective 2 – Rebalancing a Portfolio over Time

The second idea goes to the importance of compounding. One famous comment by Charlie Munger, a close associate of Warren Buffett is: 'the first rule of compounding is to never interrupt it'. 

There is often a tendency to fiddle with investments over time, rather than let the portfolios compound. Regular trading is not ideal – it increases the costs of the portfolio (transaction costs), and may lead to capital gains tax having to be paid. Effectively it interrupts the underlying compounding of the investments making up a portfolio.

An anecdote to overtrading to manage asset allocation changes is to consider rebalancing using portfolio cashflow things like contributions, tax refunds and dividends. For example, let’s consider an investor who wanted to take on more growth assets during the COVID-19 downturn over the past 14 months or so. A great adjustment for them would be to take on more exposure to growth assets while markets were down by using their superannuation contributions plus any portfolio income to invest 100% in growth assets over the period. Equally, as someone approaches retirement they may choose to increase the amount of their regular superannuation contributions (plus any extra contributions and income earned in the portfolio) that are directly invested in cash/fixed interest investments so that they reach retirement with the mix of assets that they want. In both cases the underlying compounding of existing assets is not impacted, with ongoing portfolio contributions used strategically.

Perspective 3 – A Cash ‘Call Option’ for a Downturn (and a Margin of Safety)

As well as the underlying cash allocation of a portfolio, there is an argument that some investors might like an additional buffer of cash, perhaps five to 15 per cent of a portfolio value. This cash provides another opportunity during a downturn, in that it allows an investor to be a buyer if there is a significant market drop. An investor using an income planning approach was able to more comfortably navigate the GFC and COVID-19 downturn – the addition of a strategic allocation of surplus cash would have allowed them to be opportunistic buyers during these downturns. With market falls of about 50 per cent and 40 per cent respectively in each downturn, shares were heavily discounted, and subsequent returns show that the decision to buy during this time was well rewarded. This extra cash holding is like a ‘call option’ (a financial instrument that provides the holder a right but not an obligation to buy) for an investor.

Conclusion

While decisions around the asset allocation of a portfolio are not easy, they are important. The three perspectives provided in this article, around planning for short/medium term needs, using portfolio inflows to rebalance rather than interrupting compounding and having an excess allocation of cash to be a buyer during a downturn are all asset allocation perspectives that might be of use considering asset allocation strategies. Most importantly, thinking strategically about the asset allocation decision should allow investors to be more comfortable with their own asset allocation approach.