Tuesday, June 20, 2017

Asset Allocation Part 1: The Basics


Source: Randy Glasbergen, www.glasbergen.com


As investors, we want to reap the power of compound interest over the long-run. That is how we build real wealth. But what should we invest in and how can we most efficiently allocate our savings?

This is a 3-part series of posts on asset allocation that forms the foundation of my investment philosophy. This series will tie together a lot of items I’ve been writing about over the past 2 years. Here is an outline for this series:
·         Part 1: The basics – what are asset classes, why stocks form the core of portfolios and how traditional diversification in other asset classes helps improve our Sharpe Ratio
·         Part 2: Strategic Asset Allocation (SAA) – determining the allocation for a specific investor, comparing passive vs. active funds for implementing SAA, and looking at the pros & cons of SAA
·         Part 3: Tactical Asset Allocation (TAA) – how we can more efficiently allocate to asset classes and achieve higher risk-adjusted returns

Let’s begin with the basics…


A Brief Look at Major Asset Classes

The investable universe can be categorized into what’s known as asset classes, or groups of investments that are liquid, distinct and not highly correlated with each other. 

The most common asset classes are equities (stocks) and fixed income (bonds). Domestic and foreign equities are treated as separate asset classes, since they have different risk & return profiles. Then there are the alternative asset classes such as commodities, real estate and private equity.

Historically, stocks have provided the highest returns with bonds coming in at second place. Wharton professor Jeremy Siegel shows this over a 210-year period from 1802-2012:

Source: Stocks for the Long Run, Jeremy Siegel

Let’s look at the characteristics of each major asset class to help us understand the above chart better.

Stocks:

Equities are part-ownership in businesses. When we invest in a broad stock index, we’re investing in many of the largest companies across all industries and sectors. And as owners of these companies, we believe society will continue to innovate and prospser as it has for all of human history. In the 2013 Berkshire Hathaway Shareholder Letter, Warren Buffet wrote:
"Charlie and I have always considered a 'bet' on ever-rising U.S. prosperity to be very close to a sure thing. Indeed, who has ever benefited during the past 237 years by betting against America? If you compare our country's present condition to that existing in 1776, you have to rub your eyes in wonder. And the dynamism embedded in our market economy will continue to work its magic. America's best days lie ahead." – Warren Buffet

Equities give investors returns through dividend income and capital growth. One key feature of equities (unlike owning commodities or physical real estate) is that they benefit from the power of internal compounding: many companies typically re-invest part of their earnings back into expanding the business.

Another key reason that equities provide significantly higher returns than other asset classes is due to the risk they carry. Equity earnings face uncertainty of future demand, input costs and competitive forces, to name a few. Shareholders share in the fortunes and misfortunes of companies, with no guarantee of principal repayment. And as well all know, bear markets in stocks can be severe both in terms of magnitude and duration: 

Source: stockcharts.com


Bonds:

A bond is a loan that gives investors returns primarily through interest income. This income stream is relatively stable and the investor’s principal is returned at maturity.

The major risks surrounding bonds are interest rate and credit risk. Bonds are offered in various lengths (time to maturity). The greater the length of the loan, the higher our exposure to various risks. Let’s first look at interest rate risk.

If we buy a single bond issue, then as rates rise, the value of our bond falls. This is because we are stuck receiving the older (lower) interest rate. However, we have less interest rate risk if we instead invest in a bond fund. A bond fund holds a collection of several bond issues and tries to maintain a target length. As some bond issues in the fund mature, they are replaced with new funds. Thus, if interest rates were to rise, we would take a hit on the bonds currently in the fund but we would get a discount on new bonds added to the fund. Therefore, bond funds are less sensitive to interest rates.    

Even during the 60s and 70s, when 5-year Treasury rates went from 4% to 16%, investors in a 5-year Treasury bond fund didn’t lose much sleep:

Source: US Federal Reserve Board, sharpeReturns.ca

Investors in government bonds have fairly low credit risk, as governments (particularly in developed countries) have stable revenues through taxes. This lower credit risk generally results in lower bond yields for investors.

Investors of corporate bonds carry company specific-risk, but not as much as shareholders do. This is because corporate bond investors not only receive coupon income and principal repayment, but also have priority claim on company assets over shareholders in the event of bankruptcy. Due to their lower risk profile, bonds don’t provide as high returns as stocks.


Commodities:

Commodities include base metals (eg. copper, aluminum), precious metals (eg. gold, platinum), agriculture (wheat, soybeans) and energy (eg. oil, natural gas).

The return potential for commodities is not as high as stocks for several reasons:
  • By definition, commodities and inflation are tied together:
  • Commodities have storage costs, don’t generate any income, and their returns can’t be compounded internally the way that stocks do.
  • Companies take raw commodities as inputs and continually manufacture new, innovative products at a markup (thanks to barriers to entry, intellectual property, brand power, etc.).


Real Estate:

An investment in Real Estate can either be direct (eg. owning property) or indirect (eg. REITs).

Direct real estate provides rental income and capital appreciation. The downsides are that direct real estate is illiquid, has high transaction costs and on-going costs (eg. property taxes and maintenance). Furthermore, the return potential for direct real estate is not as high as stocks for several reasons: 
  • Increasing supply is used to meet increased demand, which helps curb price appreciation
  • Local housing prices are anchored to inflation through rents and incomes. If housing prices are rising rapidly faster than rents and incomes, it is not sustainable since it means residents are either stretching themselves to own a home, or that the alternative to buying (renting) is more economical.
  • Real estate prices are impacted by interest rates the way bonds are. When rates rise, mortgages are tougher to afford, and housing prices fall. Conversely, when rates fall, housing prices rise. In a low interest rate environment like today, housing prices are high. If you were to buy a home and rent it out, the rental yield would be low, similar to the interest yield on a bond.
  • The local salaries that drive real estate prices are generated by the business sector. It would be unsustainable for companies to increase wages for their employees faster than the growth in business revenue. This is an indirect way to show that real estate is inferior to stocks.

The following chart shows US home prices in real terms since 1880. We see that housing has barely outperformed inflation over the long-term despite a growing population. 

Source: Robert Shiller, 2012


It should be noted that REITs (real estate investment trusts) on the other hand act more like stocks, since companies are re-investing capital to buy new properties or finance the development of new projects.

Before we conclude the brief tour of asset classes, I would like to point out that each asset class doesn’t operate in a vacuum. See our previous post: Markets are Interconnected.


How Diversification Helps

Because of their high long-term return potential, equities form the core of traditional investment portfolios. However, we cannot passively have our entire portfolio in equities since they are volatile. 

Source: prabook

In 1952, Harry Markowitz discovered an interesting property: by adding bonds to an equity portfolio, you can significantly reduce portfolio volatility without sacrificing much in the way of returns. The graphical representation of this is called the Efficient Frontier and forms the basis of Modern Portfolio Theory. It is shown below.


The purpose of the Frontier is to show that proper asset allocation can give investors more reward per unit of risk that they take. For example, portfolio B on the Frontier contains 33% bonds while portfolio D contains 100% bonds yet B has significantly higher return for the same level of risk as D.

How can this be? The key is that stocks and bonds tend to be uncorrelated. While both stocks and bonds have positive expected returns in the long run, they tend to respond differently to market forces (though not always). So, by diversifying into multiple, uncorrelated assets, a downturn in a single holding won’t necessarily spell disaster for your entire portfolio.

Stay tuned for part 2, in which we’ll look at strategic asset allocation.


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