Sunday 21 September 2014

Asset Allocation redux

I've posted some of this before but was about to use it elsewhere.  I thought it might be a good summary to keep here too.  I greatly appreciate any feedback - I know it's not the easiest read.

Somewhere between 40% and 100% of a fund's return is determined by Asset Allocation.  The key thing, though, is asset allocation is actually something we can control: we can't control whether the Australian share market will go up or down over the next year, we can't control if particular stock picks or a fund manager will underperform or outperform an index.  As well as investment costs, what we can control is asset allocation.

Asset allocation is simply the selection of the proportion of assets we allocate to different investments. At a high level this can be the split between growth assets (such as shares) and more defensive assets (such as cash).  At a detailed level we can think about how much of our share allocation we want to allocate to Australian shares vs. international shares, or even more granular such as separating our allocation to Large Company shares vs. Small Caps.

This post outlines my thinking about asset allocation and links to some of the sources that have helped me think about asset allocation.  Let's start with emergency funds and liability matching before discussing the high-level split between growth and defensive assets.

I won't spend too much time on the personal finance side but will briefly put into context having an emergency fund.  Your emergency fund, what Scott Pape calls a 'mojo  bucket', needs to be there for you...well...in an emergency.  You don't want to have to sell stocks in a down market that coincides with losing your job.  So keep your emergency fund in safe, liquid assets such as an online savings account. While people differ in their approach, I consider my emergency fund separate from my asset allocation. Your asset allocation for retirement should be rebalanced periodically to keep the level of risk being taken consistent, the emergency fund probably shouldn't be part of that process.

Another bucket that should be kept in safe and liquid assets comes under the heading "Liability matching".  This is about setting aside money for known or likely expenses (liabilities) such as a house deposit, school fees or a likely needed car replacement when the bomb kicks the bucket.  Again, for expenses in the next five years (roughly), we want to be able to meet those goals no matter what the share market is doing so keep these savings separate from your asset allocation for retirement (or more generally financial independence; you may still choose to work after reaching it!)

Once we've set those aside, how should we think about our asset allocation for retirement or financial independence?  To start with, for a single goal we should have a single asset allocation.  If funds are for the long term, learn to think of them as one big bucket.  That means we should consider the combination of our Superannuation with our other long-term investments when considering our asset allocation.

The first step is the high-level split between growth assets (shares, property, etc.) and defensive assets (cash, bonds).  Larry Swedroe has some advice on high-level Asset Allocation in his book The Only Guide You'll Ever Need for the Right Financial Plan.  Some of the tables are reproduced in a blog post by Canadian Couch Potato.  I'd recommend checking out the post (or even the book).

The key message is to take risk based on your "ability, willingness and need to take risk".  Ability to take risk has a lot to do with timeframe: if you have a stable income, are saving for retirement and aren't planning to retire for another 25 years you have a greater ability to take risk than someone already in retirement.  This is often what is taken into account when prescriptions such as 'your age in bonds' are made.

The willingness and need to take risk are sometimes neglected in this analysis.  For example, on the willingness to take risk, if the possibility of a 40% or 50% short-term loss will prevent you sleeping at night then a 90% or 100% asset allocation to shares is probably unwise (if nothing else because there's a chance of panic in the face of a loss, leading to selling when the market is at a low).  On the need to take risk, if you already have enough savings to last your lifetime then you can afford to take a more conservative allocation even if relatively young.  If your long-term goals require a higher return then a more aggressive allocation may be required to reach those goals (but then willingness to take risk needs to be higher given the risk of falling short).

For example, my parents have pretty much enough.  They have a low-moderate need to take risk (they can't go without growth assets due to inflation).  They have a low ability to take risk as they are mostly retired so can't wait forever without drawing down their investments.  They have a low willingness to take risk.  Mike Kemp, on the other hand, has a low need to take risk. a high ability to take risk (has more than enough to get by) and perhaps a high willingness to take risk (he's been through enough ups and downs to know he can stomach a substantial fall in the market).

Have a look at the suggestions in the tables to get a sense of where you sit.  For historical Australian asset class returns, the Vanguard chart has detailed return information on page 4.

There are some interesting approaches I've come across based on these principles.   Rick Ferri proposes starting with a reasonably conservative asset allocation when young, until you become better informed and more experienced with your degree of comfort with the ups and (more importantly the) downs of the share market.  Rick also points out that getting close to the right asset allocation is usually best, rather than worrying down to that last 3%.

The second step is to consider how to allocate to within the classes of growth and defensive assets.
Let's start with the growth assets and consider shares from different countries and regions.

Back in the early days of finance theory some would have suggested we hold the global market proportionally.  This would mean holding approximately 2-4% in Australian shares.  Yet we see most balanced superannuation funds have somewhere between 50-75% of the growth assets in Australian shares and property.

There are a few reasons for this, some of them good reasons for 'home bias'.  I won't go into finance theory but will focus more on the practical reasons:
- Australian residents (and our super funds) are usually eligible for franking credits from dividends.  In our superannuation funds this will often reduce the overall tax paid on earnings of the fund and so increase after-tax returns
- Currency fluctuations can also impact international share returns in Australian dollars.  However in an international fund hedged to the Australian dollar, imperfect currency hedging can be a drag on returns (and lead to increased tracking error: make it more difficult for a manager to track their index)
- Australians may just be more comfortable with local shares, making some 'home bias' more marketable

Having some international exposure is likely to be beneficial over the long term.  The key reason is diversification - when they're not perfectly correlated (don't always move together in the same direction) diversification of volatile assets with similar expected returns can actually lead to higher returns with lower risk.  For more on the conceptual details of this I strongly recommend reading one of the books below by William J. Bernstein or Chapter 3 of the Road Map for Investing Success website.

Unfortunately we can't know ahead of time which combination of assets will perform best over the next year, 5 years, 10 years, or 30 years.  So some criteria I see as important are:
Having a sufficiently diversified portfolio to smooth possible outcomes
Having a portfolio containing a balance of assets which still allow you to sleep at night!

The latter criteria may not seem entirely rational.  My key point with it is that making constant changes to your asset allocation (for example purposely lowering your allocation to US shares when they're doing badly relative to Australian shares, say) is paradoxically a good way to lose money (as we're selling low and buying high).  And if you're not comfortable with, say, more than 50% international shares it greatly reduces the chances of 'staying the course' during the inevitable ups and downs.

Other growth assets include Property (direct holdings and REITs) and Infrastructure.  My personal view of these asset classes is that small proportions in your Industry Super fund may be good diversifiers.  I personally don't like holding more residential real-estate than needed as a lifestyle choice.  For a start I don't consider the house I live in as part of an asset allocation, as it doesn't put money in my pocket.  It does reduce the amount I need for expenses in retirement against renting though. And residential property suffers from high transaction costs, low liquidity and an inability for most of us to diversify.

Many industry funds can provide suitable access to more diversified property and infrastructure.  I prefer these to separate REITs and listed infrastructure funds as they retain some diversification while being less likely (at present) to see a 'reach for yield' that may reduce the margin of safety for REITs. This may change, of course, as competition for these assets increases.

You can get even more granular but make sure you're across the basics first.  For example, some (including me) see an advantage in diversifying further across 'factors' such as Value or Small Cap stocks.  Approach this with caution and only after substantial reading as part of a larger plan.

For defensive assets I focus on online savings accounts, term deposits and Australian bonds.  These are held to reduce portfolio volatility so keep your defensive assets in Australian dollars (or at least hedged to the Australian dollar - given the differences in interest rates across 'safe' developed countries at present international bonds seem unlikely to provide a higher risk-adjusted return). Outside Super I stick to online savings accounts (e.g. UBank) which are government guaranteed and have a high expected yield even relative to Australian government bonds.  In Super I do hold a small amount of a bond fund. These can fluctuate in value but not nearly to the same extent as shares and often in a different direction from shares.  For my parents we've split up their (majority) defensive allocation between cash and bonds.

Step three: Once you have a planned asset allocation find the best tools to implement it.  As previously mentioned, if you want (non-residential) Property and Infrastructure an industry super fund is my chosen starting point.  Due to preferential tax rates it may be advantageous to hold more of your defensive assets in Super also (franked dividends, foreign tax credits and capital gains discounts all work similarly inside and outside super for shares, while cash and bond interest tends to get a better tax treatment in super for those on average or higher incomes).  As this post is more about building a framework for asset allocation I won't go into more detail here.  I just include it as a distinct step as we tend to go straight to the investment rather than looking first at the part it plays in our portfolio.

References

(1) Ibbotson, R. G., & Kaplan, P. D. (2000). Does asset allocation policy explain 40, 90, or 100 percent of performance?. Financial Analysts Journal, 26-33.

(2) Ready, Willing and Able to Take Risk

(3) Vanguard 2014 Index Chart

(4) The Flight Path Approach to Age-Based Asset Allocation

(5) Horseshoes, Hand Grenades and Asset Allocation

Unfortunately there isn't an easily accessable book on Asset Allocation specifically targeted at Australians.  However some other useful and readable sources of information include my favourite books on Asset Allocation, by William J. Bernstein:
The Investor's Manifesto: Preparing for Prosperity, Armageddon, and Everything in Between
The Four Pillars of Investing: Lessons for Building a Winning Portfolio [a little more technical]

The MoneySense Guide to the Perfect Portfolio is a very short book, costs $4.99USD on Kindle/iPad and provides a nice first introduction to Asset Allocation with index funds.  While the Bernstein books above are written from a US perspective, this one is Canada-focused.  So the specific products are different (e.g. we have Super, not RRSPs) but many of the challenges are similar: Asset Allocation in a country with a relatively small, undiversified local stock market (skewed towards Financial and Commodity stocks) and an economy and (perhaps overheated) housing market that survived the GFC.

Road Map for Investing Success
The Bogleheads on Asset Allocation
Vanguard paper on home bias
The Rewards of Multiple-Asset-Class Investing by Roger Gibson:

Frequently Asked Questions and Examples

Should I be worried about Foreign Currency fluctuations with my International Shares?
If you have a long time until these investments are needed (until retirement, and keeping in mind your retirement may last 30 years or more) then no.  Over the long-term we can expect the fluctuations to average out.  In fact, keeping in mind past performance does not guarantee future results, JP Morgan found that diversification benefits are improved for Australian funds with less than about 50% in International Shares if they do not hedge:

That said, while there is some cost to hedging, many super funds hedge part or all of their foreign currency exposure (often splitting the difference at 50%) and it's not unreasonable to do so.  If you invest internationally through Super, managed funds or ETFs then there are fully and partially-hedged funds available.

Australian Shares have performed well.  Why should I diversifiy internationally?
There's a lot of evidence that international diversification works in the long run.  See here for e.g.
It's easy to get complacent, look at the Vanguard chart (3) and say Australia hasn't had a bad year for shares when other countries have had a good year since 1998.  That's recency bias talking.  The US can have its internet boom and bust, Japan can have a decade or two of underperformance and there's every possibility that there will be years over our investing lifetime when Australian shares will underperform relative to international shares.  That's a risk we can at least mitigate by diversifying internationally, and these days the cost of doing so is low.

How can I see my Super and other investments as one big portfolio asset allocation?
For example [just a simple example of how to calculate it, not a recommendation], consider a case where 50% of our long term investments are in super, half outside.  Our investments outside super are 80% Australian Shares, 20% in an online savings account (over and above our emergency fund), while our Super is in a Diversified fund which the fund website tells us is:

Australian shares 34%
International shares 36%
Fixed interest 12%
Cash 18%

Then our Australian Shares are 50% * 80% + 50% * 34% = 57% of our portfolio
International Shares are 0% + 50% * 36% =  18% of our portfolio
Defensive assets (Cash and Fixed interest) are 50% * 20% + 50% * (12+18)% = 25% of our portfolio

1 comment:

  1. I discovered your blog through MMM. Thank you for your research on Australian Super Funds it is very helpful. I have tried to use your email link but it doesn't seem to work.

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