Asset allocation gets personal

In cartoon blockbuster Kung Fu Panda, protagonist Po’s father is renowned for his soup: the best in all of China, with a secret ingredient that’s handed down through the generations.

Po makes a mean soup himself but longs for the secret ingredient to make it complete. Then, at a critical juncture in the movie, his father reveals the secret: there is no secret ingredient.

Asset allocation is a bit like that soup. Talk to a bunch of professionals and they’ll likely tell you about ‘optimal asset allocation’, an idea based on Modern Portfolio Theory (MPT).

But the trouble with MPT is that it relies entirely on historical data, and the assumption that future returns and volatility (synonymous with ‘risk’ to the academics) of individual asset classes will match past experience.

Those with real world experience know that while history is important, it won’t allow you to predict the future; MPT is not the secret ingredient that will give you an ‘optimal’ asset allocation.

The good news is that by understanding some basic principles and applying common sense, you’re likely to be as well – if not better – placed than the experts. Not only that, but we self-directed investors have some extra ingredients of our own.

Volatility is not risk

Let’s start with ‘volatility’ which, as we saw in A dance through the financial aspects of risk , isn’t risk at all. But asset allocation experts building large financial models need measurements and it’s simply not practical to assess each individual asset for the risk of capital loss. So the experts have made do with volatility as a proxy.

But if we’ve correctly placed ourselves on the risk spectrum, volatility is not a risk for us: our concern is not about how our investments perform over a month or a year, but how they meet our requirements over our lifetimes.

The second limitation of traditional asset allocation highlights one of the major benefits for us as self-directed investors: a large fund manager might have thousands of clients, so their asset allocation is geared towards the hypothetical ‘average investor’. But you’re not the average investor. You’re you. And one of the great things about being a self-directed investor is the ability to take into account your own personal circumstances.

In A dance through the financial aspects of risk we discussed the concepts of human capital and financial capital and the fact both need to be taken into account. So let’s examine some of the principles that will go into making your own personal asset allocation soup.

Your job

The ability to earn a salary drives the value of your human capital. If you’re young, or young-ish, it’s probably the main asset you have. A superannuation balance of $200,000 pales beside the ability to earn $100,000 a year for the next thirty years.

In assessing the value of your human capital, there are two main questions to ask yourself.

First, are you earning a salary that will be hard to replace? If you’ve gone from being an electrician to a mine worker earning $200,000 a year, you probably couldn’t go back and earn that amount in your old job. In this case, the value of your human capital is strongly related to the resources industry.

The other question is how secure is your job, or your ability to earn income. For instance, the specific job of a waiter might not be very secure but he’d probably back himself to earn a similar amount elsewhere. On the other hand, a translator working for a Korean company in Italy might find it very difficult to replace their level of income if their job disappeared.

If you’re in a role with little security and above-average income, what would that mean for your portfolio?

Firstly, you should be relatively more conservative. You never know when you’re going to have to draw on your savings (or not be able to continue adding to them). Borrowings, in particular, should be kept to a minimum.

But you should also aim to hedge your bets, to a degree, with your investment portfolio. A mine worker earning $200,000 a year, for example, might want to limit their exposure to Australian resources shares (and possibly Australian shares generally). Similarly, a banker with a bunch of share options might have a lower than average allocation to Australian bank stocks, or leave them out of their portfolio altogether.

Your house

Another major factor for many Australians is the exposure of their financial capital to property prices.

If you’re intending to downsize at some point, then your home is partly an investment in Australian residential property and partly a prepayment of living costs. People in this situation might find they have a large allocation to residential property by default. In this case you might consider reducing your portfolio’s exposure to property, banks and Australian shares generally (see Macro Investing: A property price bubble? for further discussion of this point).

If you plan to live in your current home (or one of similar value) indefinitely, then you’ve effectively prepaid a living cost, not made a property investment. In this case, as long as you own your house outright, or can comfortably afford your mortgage payments, then you should simply ignore your house as part of your investment portfolio’s asset allocation.

Investment properties

Due to the large minimum investment size (especially in capital cities), an investment in property typically leads to a lack of diversification.

Part of the reason investors are untroubled by this is that the asset class (residential property) has been a strong performer for a long period, which can lull people into a sense of ‘exceptionalism’: that this asset class is different to others. This always ends badly in the world of investing.

Imagine you have a super balance of $300,000 and a $500,000 investment property in Sydney that you borrowed $400,000 to buy. You’ve ended up with more than 60% of your assets not only invested in a single asset class but in a single asset.

Your super might return 7% per annum but, if your property only breaks even (not even contemplating the disastrous results seen in several other countries), then you’ll be going backwards due to the interest on the property loan. If something really bad happens – for instance, a large interest rate increase or a big repair bill – you could end up way behind the eight ball.

Someone in those circumstances has become an ultra-high conviction investor: betting almost everything on things turning out well for that individual property and, in the process, tossing aside the idea of diversification and asset allocation. It’s not necessarily the wrong approach, just very aggressive. And a riskier one than many employing it probably realise.

If you’ve got a $5m investment portfolio and are investing $500,000 in a single property, then it’s a completely different situation. A good asset allocation will help shield you, especially if you keep exposures to Australian banks, builders and property development companies to a minimum.

Asset allocation through time

The next principle is that your asset allocation needs to allow for future events. If you’ve got a large cash outflow occurring a year from now – a $50,000 home renovation for example – then this amount should be deducted from your cash holdings.

You might have $200,000 split equally between cash, fixed interest, Australian shares and international shares. But, taking your known expenditure into account a year hence, you’ve really only got $150,000 split three ways with no cash allocation.

Similarly, if your Great Aunt passed away last month, leaving you $100,000 from her estate, you can probably count this as ‘cash’ even though it’s not yet actually in the bank.

Summing up

These examples highlight why asset allocation is such a personal exercise. Two investors may have exactly the same conservative risk profile but one might currently hold 50% in cash, while the other has only 5% because of circumstances peculiar to themselves.

Remember there’s no secret ingredient for making these adjustments. Like Po, you need to understand your own strengths and weaknesses and make your own way – just go easy with the high kicks.