If you see your financial advisor they’ll likely recommend that you allocate your assets between property, stocks, and cash (partly due to the tax incentives for real estate and equities in Australia).
That’s because all asset classes have summer and winter seasons.
Source: Novel Investor
Sensible asset allocation can help you to adopt a disciplined, long-term approach to building wealth, while helping you to see the big picture.
And while one asset class isn’t delivering another might be, so this can bring smoother risk-adjusted returns to your portfolio.
However, because of increasing globalisation over the past 30 years or so, certain asset classes may have increased in their correlation, so it may not be quite as simple as it used to be.
Source: Novel Investor
Still, asset allocation remains an important investment principle that we use to minimise risk and maximise our investment returns.
Asset allocation and timing
The legendary football player and then coach Knute Rockne once said:
‘As a coach, I play not my 11 best, but my best 11.’
This is also how you should think about your portfolio.
Even if equities are the best performing asset class over the long term, your timing is still important.
Closer to home, astute asset allocation is aptly demonstrated by Australian residential property in Sydney and Melbourne booming while the ASX meandered back and forth.
Asset allocation – in two parts
(i) Macro allocation
This simply means dividing your funds between your chosen asset classes, and partly because of tax incentives in Australia this allocation is normally dominated by stocks and property.
We can also include cash and bonds as they can be useful asset classes for protecting capital.
Since we understand market cycles, we believe there is ample evidence to show that moving between asset classes at the macro level can increase your returns.
For example, investors in Sydney in 2011/12 made excellent investment returns simply by choosing property when it was on the cusp of a large increase.
The same can be done for stocks using market cycles and the CAPE ratio.
With the advent of ETFs, which allow us to buy country indexes, US sectors, and styles, we can use the cycles to increase our returns.
When stocks are cheap, you should consider allocating more of your funds to stocks in order to gain from the increased returns on offer.
When stocks are expensive and offering minimal or below-average returns, then you should pivot to alternative asset classes such as property or cash.
Remember, cash has an important role to play because it’s uncorrelated with stocks, it gives you a safety buffer, and it gives you the optionality to buy stocks when they do become cheap.
(ii) Micro allocation
Micro allocation is how we divide our funds once we have determined our macro allocation.
An example will suffice.
Let’s use US sector ETFs, where we might be looking to invest in the most out of favour sectors.
Then we would go on to look at the CAPE ratio for each sector.
You may choose three methods to invest:
- Invest in all the out of favour sectors equally because while some investments will seem more appealing and appear to have more potential, you can’t always be sure; or
- Invest in all sectors but adjust the initial amounts according to some indicator (you may choose a greater weighting based on market cycles and where the sector performs best in through the business cycle); or
- A judgemental selection of sectors – we believe this is a sound approach as it allows you to adjust your allocation according to our 8 timeless principles (for example, mean reversion and CAPE ratios)
Under this method, you would select those sectors that have the best expected returns.
We often favour buying the bottom three performers (‘the losers’), and then allowing mean reversion to play its role in delivering solid investment returns.
Notice how over an extended period that no one sector dominates, and so they swap positions.
Leaders become laggards, and vice versa.
Many investors over-allocate or allocate the full 100% of funds rather than keeping some cash allocated against the stock.
This is often done because you think the opportunity is so good.
So many folks leave themselves no wriggle room or opportunity to buy after their initial allocation.
However, it’s more prudent if you choose $10,000 as your potential allocation, to initially spend $5,000 and hold $5,000 against it in cash.
After all, none of us is clairvoyant – we can’t pick the bottom of the market precisely – and so it pays to keep some of your powder dry in case the price sinks lower.
This can often be the case because you are buying when the sector or country is out of favour – but remember that is when the best returns are on offer.
Cash is (sometimes) king!
Cash is uncorrelated to equities, and is important for several reasons.
Firstly, cash gives you options.
As Warren Buffett said, holding cash is painful but a lot less painful than making a dumb investment decision and losing money.
Although we can’t predict what future opportunities may arise, cash allows you to take advantage of them when they do.
Secondly, having cash against each stock allows you to add additional funds if the stock falls.
We’ve found this to be very reassuring psychologically.
We have the knowledge and emotional comfort of having cash available should the stock price fall, and so we can put our cash to work and realise that we are reducing our average entry price as the stock falls.
And over time you will find that holding cash (which does at least earn a small amount of interest) helps you to outperform the market.
Remember: Markets can be volatile!
And this volatility can be your friend because it throws up opportunities.
Holding spare cash gives you a greater range of options to add more stocks during those intra-year declines.
Stock markets can fall 20% to 40% in a very short space of time, and if you have cash, you can take full advantage of these falls.
Even better, when the CAPE ratio is low – and by now we hope you are realising what type of market and where in the cycle you are presently – it is important for asset allocation.
You can adjust your asset allocation according to the expected return.
Expected returns are not an exact science, but in general, we know that when the expected return is high, you should consider increasing your initial allocation.
So if the expected return is high (as happens when asset classes are cheap and out of favour), then you may, for example, start with a 70% allocation and hold 30% in cash.
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