As Ray Dalio, the founder of Bridgewater Associates, the largest hedge fund in the world, puts it:
"You should have a strategic asset allocation mix that assumes that you don't know what the future is going to hold."
The world is unpredictable. Just over two years ago, who would have imagined a global pandemic, a Russia-Ukraine war, and record inflation last seen 40 years ago?
How do you allocate assets strategically to be ready for such events?
What is strategic asset allocation?
Strategic asset allocation is simply about not putting all your eggs in one basket. You invest across asset classes according to your goals, risk tolerance, and investment horizon.
The baskets should be somewhat uncorrelated for asset allocation to work. They should react differently in different market environments.
Consider a portfolio of equities and bonds. During a recession, the value of equities drops. As the central bank reduces interest rates to stimulate the economy, the value of your bonds increases, offsetting the drop in equities and reducing your portfolio volatility.
This diversification is heralded as the only free lunch in investments.
The importance of strategic asset allocation
Although diversification is widely acknowledged as a basic principle in investment, concentration has its proponents. They often cite Warren Buffet's quote that "diversification is a protection against ignorance, and that it makes very little sense for those who know what they're doing."
However, concentration is very risky. Even the most successful experts who know what they are doing can make costly errors of judgment. For instance, in five short months in 2022, Tiger Global, the legendary hedge fund which had compounded annual returns of 20% historically, lost two-thirds of its gains since 2001 after concentrated bets in technology went awry.
Most investors who do not have the time or informational edge would be well advised to spread their bets across asset classes and stay invested consistently across all market environments.
One should approach asset class allocation like the weather. The day-to-day weather is unpredictable, but the overall climate is fairly consistent whether you are in Riyadh, Los Angeles or Antarctica.
In other words, your returns will be broadly similar to other investors with a similar asset allocation, regardless of the underlying investments.
Asset allocation strategies
There are several approaches to asset allocation. One is age-based. A rule of thumb is to subtract your age from 100 to determine an asset allocation between high-risk and low-risk asset classes. For instance, if you are 40 years old, you should invest 60% in equities and 40% in bonds.
As you grow older, you would increase the percentage allocated to bonds as your risk appetite decreases. Should any asset class outperform, you would rebalance your portfolio to restore the asset-class split to the planned level. Life-cycle or target-date funds help you do that.
You can also adjust the asset allocation parameters based on your risk profile and investment horizon. For instance, private market investments are less liquid and require a longer holding period. But they offer higher returns than public market investments. Investments in developed markets or large companies are also less risky than investments in developing markets or small companies.
Generally, several asset classes react differently and perform different functions in a portfolio, such as:
Asset allocation realities today
As we move into a rising rates environment, the classic 60-40 portfolio of public equities and bonds no longer works. In the first half of 2022, equities and bonds have fallen in tandem as rising rates have caused the valuation of both to decline.
However, other strategies can replace public bonds. For instance, private credit with flexible interest rates can be a suitable replacement. Market-neutral strategies, such as hedge funds or niche strategies (like life settlements, which entail the sale of an existing insurance policy for more than its cash surrender value) can also fill the void.
The Family Office has helped its clients preserve and grow over US$2 billion of wealth since 2004. We customize a strategic asset allocation mix according to the risk tolerance and investment time horizon of each investors. Our global reach and scale can also help you access asset classes that are available only to the largest investors, such as private markets investments.
Call us today to construct your bespoke portfolio.