The Key to Effective Portfolio Construction Starts with Asset Allocation

Asset allocation is the foundation of a well-constructed portfolio. By strategically dividing your investments among different asset classes, you can manage risk and increase potential returns.

A study of 2,000 investors found that those who implemented a diversified asset allocation strategy outperformed those who didn't. This is because asset allocation allows you to spread your investments across different asset classes, reducing your exposure to any one market or sector.

A simple 60/40 stock-to-bond allocation can be a good starting point for many investors. This allocation has historically provided a balance of growth and stability, with stocks making up 60% and bonds making up 40% of the portfolio.

Asset allocation is the process of deciding how to divide your investment across several asset categories, such as stocks, bonds, and cash or cash alternatives. This process involves diversifying your portfolio by allocating money to various asset classes, which is crucial in minimizing market risk or systematic risk in mutual fund investments.

Diversification is key to asset allocation, and it's essential to understand that different asset classes don't move at the same pace or in the same direction. This is why having the right mix of investments is important, as it allows you to minimize your risk and maximize returns.

The most famous phrase you might have heard is 'Never put all your eggs in one basket,' which perfectly describes asset allocation. This phrase underlines the importance of diversification in mutual funds and highlights the need to choose schemes that offer sectoral diversification.

Asset allocation depends on your age, risk-taking ability, and time horizon for the particular goal. It's not a static process, and your target allocation will change over the course of your life as both your willingness and ability to bear risk change. Understanding the investment process is crucial in guiding these asset allocation decisions to meet specific financial goals.

To calculate your asset allocation, you need to consider your investment horizon, risk tolerance, and long-term financial goals. An investor with a longer investment horizon may lean more towards stocks for potential growth, while those with shorter horizons might prefer bonds or cash for stability.

Here's a simple example of how to calculate your asset allocation:

In this example, the distribution of the investment is across three broad asset classes: Stocks, Bonds, and Cash equivalents. This distribution reduces the level of volatility associated with the portfolio.

Regular rebalancing is also essential in maintaining your desired asset allocation. This involves periodically buying or selling assets to restore your portfolio to a desired asset allocation. Because assets appreciate at different rates, a portfolio that's 60% stocks and 40% bonds on January 1st could be 75% stocks and 25% bonds by the end of the year.

Alternative investments can be a great way to diversify your portfolio and potentially increase returns. The strategy team proposed increasing the allocation to alternative investments, which would raise the allocation to private equity from 18% to 23% and real assets from 13% to 16%.

This increase in alternative investments is not without its risks, however. The committee is questioning whether the increased exposure to private equity is justified, citing higher standard deviations than previously estimated.

The strategy team used unsmoothing techniques to remove the impact of serial correlation on risk estimates due to outdated market pricing. This revealed that the proposed alternative investments have higher standard deviations than previously thought.

Building exposure to alternative investments over time can actually improve portfolio diversification and expected returns. The endowment in question has been building exposure to these strategies over the last two decades in a gradual manner, resulting in well-established, mature, and well-diversified illiquid portfolios.

However, the strategy team should also examine whether the allocation to private equity and real assets is exposed to idiosyncratic risk factors, which could mean more risk being taken on than intended.

Having a strong network of connections in the industry can also be beneficial when investing in alternative assets. The endowment has developed a strong network of connections in the industry, which has helped them gain access to best-in-class managers in these spaces.

A 75-25 equity-bond split is a good starting point for portfolio construction, and the 60-40 split is another well-known option.

Younger investors generally should have more exposure to risk, given their longer time horizon. This is because they can afford to bear volatility over a longer period.

The "Age in Bonds" method is a historical way to calculate the stock-bond split, where you subtract your age from 100 to determine the percentage of bonds in your portfolio. A more aggressive approach is to use "Age minus 20 in Bonds".

Investors with more than 5 years to go until they need the capital should be predominantly invested in stocks.

A good starting point for constructing an effective portfolio is to consider a 75-25 equity-bond split or a 60-40 split, which is perhaps better known.

The pyramid showing the risk/return profile of main investments is a useful tool to gauge where to head first.

Younger investors generally should have more exposure to risk, given that they have a much longer time horizon over which to bear volatility.

The "Age in Bonds" method is one historical way to calculate the stock-bond split, although a slightly more aggressive "Age minus 20 in Bonds" is also common.

It's generally accepted that you should be predominantly invested in stocks when you have more than 5 years to go until you need the capital.

Being the most volatile, alternative investments like cryptocurrency, venture capital, and P2P lending should generally not comprise more than 10% of a standard portfolio.

These alternative investments are also the most subject to wild swings in value, and will hence probably need to be rebalanced more often.

Rebalancing your portfolio is a crucial step in maintaining your target allocation. It's like adjusting the sails on a boat to stay on course.

There are three ways to rebalance your portfolio: sell investments that are overweighted, buy investments that are underweighted, or alter your regular contributions to push your trajectory back towards your target allocation.

Selling overweighted investments can help you free up cash to invest in underweighted areas of your portfolio. This can be done by selling a portion of the investments that have grown too large.

Buying underweighted investments can help bring your portfolio back in line with your target allocation. This can be done by investing in assets that are currently underrepresented in your portfolio.

Alter your regular contributions to push your trajectory back towards your target allocation. This can be a more subtle approach, but it can be effective in the long run.

Here are the three ways to rebalance your portfolio in a concise list:

Implementing a new asset allocation strategy can be a complex and costly process. Private equity and private real estate strategies often come with higher investment management fees and performance fees compared to fixed-income and public equity strategies.

These higher fees can eat into your returns, so it's essential to consider them when making investment decisions. The team analyzed the costs associated with implementing the proposed portfolio allocation changes and incorporated the impact of higher expected investment management fees arising from higher allocations to more illiquid investments.

By using returns net of fees, the team was able to get a more accurate picture of the potential costs involved.

Liquidity is a critical aspect to consider when implementing a new asset allocation strategy. The endowment's liquidity management framework is being improved to better manage cash outflows and inflows.

The committee member is concerned that the portfolio's liquidity characteristics will deteriorate in periods of severe market stress. This is due to capital calls in private markets exceeding capital distributions, activation of gates, and the smoothing effect.

Capital calls in private markets can increase the allocation to private markets in the overall portfolio, making it more difficult to meet liquidity needs. Activation of gates can also restrict investor withdrawal requests during stress periods.

The smoothing effect can lead to a relative increase in the portfolio weighting of private markets and a relative decrease in the weighting of more liquid assets. This can impact the percentage of assets available to satisfy liquidity needs.

To address these concerns, the team has analyzed the current and proposed portfolios under normal and stressful market conditions. The proposed asset allocation implies a shift toward more liquid investments.

However, this shift also results in an increase in the overall illiquidity profile due to a higher percentage of the portfolio being invested in private equity and private real estate. These are the most illiquid asset classes in the portfolio.

The team needs to ensure that even under stressful conditions, the proposed allocation continues to comply with the liquidity budgeting framework in place. This framework satisfies the various liquidity needs of the portfolio for both cash outflows and rebalancing.

To monitor the portfolio's liquidity profile, the team should closely track changes in the asset allocation and stress test the portfolio periodically. This will help ensure that the portfolio's liquidity remains adequate.

Here's a summary of the proposed allocation's impact on the portfolio's liquidity profile:

Note that the proposed allocation results in a reduction in the highly liquid and liquid categories and an equal increase in the semi-liquid and illiquid categories. This highlights the need for careful monitoring and stress testing to ensure the portfolio's liquidity remains adequate.

Private equity and private real estate strategies typically have higher investment management fees than fixed-income and public equity strategies.

These higher fees can lead to a significant impact on investment returns, making it essential to consider them when making portfolio allocation decisions.

Investment management fees for private equity and private real estate strategies can eat into your returns, so it's crucial to factor them into your calculations.

Private equity and private real estate strategies often come with performance fees on top of investment management fees, further reducing your potential returns.

The team analyzed the costs associated with implementing the proposed portfolio allocation changes, incorporating the impact of higher expected investment management fees arising from higher allocations to more illiquid investments.

Using returns net of fees helps to get a more accurate picture of your potential returns, taking into account the fees associated with private equity and private real estate strategies.

Investing $230K in the S&P 500 all at once can be a bad idea, as it may lead to overexposure to the market and increased risk of losses.

Dumping a large sum of money into the market at once can trigger significant capital gains taxes, reducing your overall investment returns.

This strategy can also lead to overpaying for investments, as you're buying at the current market price rather than potentially lower prices that may arise from dollar-cost averaging.

Investing a lump sum can be equivalent to buying a bunch of stocks at the same time, which may not be the most efficient way to build wealth over time.

By investing all at once, you're essentially betting on the market's performance, whereas a more balanced approach can help you ride out market fluctuations.

Diversification is key, and investing a large sum in a single index fund or ETF can leave you vulnerable to market downturns.

In contrast, a dollar-cost averaging strategy can help you invest a fixed amount of money at regular intervals, regardless of the market's performance.

This approach can lead to more stable returns and reduced risk over the long term, making it a more attractive option for investors.

Portfolio construction starts with asset allocation, and understanding the performance of different asset classes is crucial in making informed investment decisions.

In the past two decades, the NIFTY 50 and Gold have shown a weak correlation in their performance. This is evident from the table showing their performance from 2000 to 2020.

Here's a brief overview of their performance during different periods:

As you can see, the performance of NIFTY 50 and Gold have been quite different during various periods, with NIFTY 50 outperforming in some years and underperforming in others.