150. (5. Building Finance Intuition) Asset Allocation — Mighty Lever for creating Wealth
“The most important key to successful investing can be summed up in just two words-asset allocation.” — Michael LeBoeuf
In my last blog on financial intuition (link here), I emphasized the importance of earnings in creating wealth. In this blog, I cover “asset allocation” which I consider to be the among the biggest levers in creating wealth. The savings that materialize from earnings become the raw material to create wealth. Given that most of us start out with very few assets, it is natural that we would like to (and also need to) maximize the return rate — we are not merely looking to get a rate above inflation but seeking a rate that is comfortably over inflation rate.
Once we find investment products that are likely to produce good returns, how much of our capital do we commit to these products? 100% given that our objective is to maximize wealth? If not, then how much lesser than 100%? Too little and we may not create enough wealth and too much and we may still not create enough wealth if the product fails to deliver. Determining this proportion is the goal of asset allocation.
“On average, 90 percent of the variability of returns and 100 percent of the absolute level of return is explained by asset allocation.” — Roger G. Ibbotson
For a long time, I struggled to distinguish asset allocation and diversification. So, a bit on that here: technically, the purpose of diversification is to reduce risk in a portfolio of investments. Whereas asset allocation is a conscious, deliberate and strategic decision to allocate specific proportions of your capital across various kinds or classes of assets — primarily, “fixed income” and “equity”.
Imagine a basket of eggs. If the basket falls, all eggs break and you may go hungry. It is better to spread your eggs across multiple baskets so that even if one or few baskets were to fall, you will still have eggs from the other baskets to quell your hunger. This way of reducing your risk is what one means by diversification.
Now imagine two varieties of eggs that change their size with time, at varying rates. The first variety of eggs, let’s call them the “batman” eggs, have in their nature to multiply their size over a long term. Whereas in the short term, they randomly either grow or shrink in size, sometimes rather significantly (say, 50%). Importantly, even if they were to reduce their size in the short term, if they are left alone, they tend to nurse themselves back to the expected long-term size. The second variety of eggs — the “butler” eggs slowly and reliably grow with time. They are dependable in the sense that when you find yourself hungry, you can be sure that the eggs are not in randomly shrunken size. Your hunger is sure to be sated. Asset allocation is the process of determining the proportion of each variety of eggs with the objective of maximizing the total cumulative volume of eggs.
“If you aren’t thinking about owning a stock for ten years, don’t even think about owning it for ten minutes.” — Warren Buffett
To be sure, by “fixed income” investments, I mean those products that have essential features of a loan that one may give out — one receives relatively fixed interest payments periodically and at the end of the term, the entire principal as well, e.g., fixed deposits, liquid or bond mutual funds. By “equity”, I mean products that bestow some kind of ownership to the investor where the underlying “owned” asset changes in value based on market conditions. Examples would be stocks/shares of companies and real estate holdings.
One popular but what I believe to be largely inadequate suggestion for asset allocation is to use quantum of one’s age as measure for debt allocation and the remaining for equities. For example, someone who is aged 30 is suggested to invest 30% in fixed income and the remaining 70% in equity. With age, allocation towards fixed income increases and correspondingly equity allocation decreases. This seems sensible because this method implies that one is reducing risk of their portfolio with age which tallies with natural increase in risk averseness that comes with age.
“The most striking thing about Graham’s discussion of how to allocate your assets between stocks and bonds is that he never mentions the word ‘age’.” — The Intelligent Investor
Although this sounded logical, I could not connect with this approach emotionally. It somehow felt constraining and too impersonal — somewhat similar to suggestions asking someone to eat 40% protein, 30% fat and 30% carbohydrates or keeping total calorie ingestion per day to 2200.
I think of asset allocation as the art of safe pursuit of wealth while keeping at bay, one’s natural risk dispositions such as greed and fear.
In practical terms, the goal of asset allocation is to maximize the likelihood of wealth creation by:
- allocating that portion of capital to equities which is not needed in the short term (typically ten years or above but this number can change based on a number of factors)
- at the same time, ensuring that you have enough reliable (aka fixed income) assets that can sustain you while the risky assets (aka equities) are given the required long rope to perform
The key to remember here is that your allocation to equity may be volatile in the short term, but it tends to grow at a fair clip over inflation in the long term. That means even if it performs badly in the short term, you do not make changes to your allocation so long as your investment thesis behind selecting individual products is valid and intact.
The other key is that the allocation to fixed income assets is not to be measured by the returns that they produce but by the number of bother-free years they allow you to grow your equity assets. As long as your fixed income assets keep pace with inflation, it may be OK.
“An asset allocation plan is based on your personal circumstances, goals, time-horizon, and need and willingness to take risk.” — Michael LeBoeuf
When I used to work, I started out with setting aside three months and then six months and towards the end of my career, about two years’ worth of expenses in fixed income assets. This did not include any retirement accounts. After I stopped working, I kept about ten years’ worth of expenses in fixed income assets. This drastic increase is because, earlier, I counted my job towards my safe assets too. Now that I don’t have the safety of a job, I had to compensate for it by significantly increasing capital allocation to safe assets. Equally importantly, all of my equity allocations are in highly volatile assets (less than ten small cap stocks) which I expect to grow well in time.
Depending on the nature of your job and your skills, you may have to vary your capital allocation to safe assets. If you are confident that you will be able to land another job quickly, then the allocation could be smaller. Other factors such as your financial condition and goals, psychological profile and relationship with volatility will also play key roles in determining asset allocation.
Bottomline
“The difference between success and failure is not which stock you buy or which piece of real estate you buy, it’s asset allocation.” — Tony Robbins
Asset allocation is the dance of balancing a number of specific (to individual) variables, few competing, in order to maximize the likelihood of wealth creation over the long term. It is a dynamic pursuit of not letting short term interfere unnecessarily with your long term. It is very similar to how we rear our young ones. We protect and provide for their first twenty to twenty-five years while they go through the phases of precarious childhood and volatile teenage, side by side, developing their competencies and capabilities, so that later on, they can create productive and beautiful lives.
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I help people make better decisions.
I coach people on “Making Better Decisions”, “Financial Intuition” and “Building Great Careers”. I’m open to run sessions on these topics in institutions — this will help me create larger impact.
I’m also an Investment Advisor (RIA) registered with the Securities and the Exchange Board of India (SEBI). As an RIA, I analyze and prepare financial plans to help people achieve their financial goals.
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