Saturday, October 25, 2014

Asset Allocation isn't the same as Diversification

Today, I will be talking about Asset Allocation and Diversification.

Intrigued by the recent post of Teenage Investor touching on asset allocation under portfolio construction, I decided to think more about it. Ladykiller also piqued my interest with his post on quants. I think appreciation of asset allocation and their branching disciplines are best appreciated by quants due to the myriad amount of mathematics involved. I was personally drawn into the finance world by asset allocation strategies.

Diversification to me is simply spreading out your risks. However, most people tend to think of diversification exclusively within the asset class of equities, hence the words "ETFs" or "funds" keep popping up. To clarify, there are ETFs that cover many broad and niche asset classes. There are even ETFs that branch across multiple asset classes! Of course these people are correct to say that ETFs and unit trusts have less unsystematic risks because there are many individual securities and exposure to each of them is capped.

However, I do not agree that ETFs are "duh, no-brainer, of course safe investments because they are DIVERSIFIED". Investors that are charmed by the allure of ETFs with their cheap and simple diversification must understand that they are only removing away the unsystematic risks within that specific asset class. Most people don't tell you, but risks goes two-ways. Downside risk, as well as upside risk. Diversifying not only protects you from the downside of owning some bad apples, but it also caps your upside on owning the really goods ones as well. By actively choosing an ETF of an asset class, you are only merely removing the unsystematic risks within the asset class. Other risks have not been "diversified" away! Don't make this mistake!

For example, rising interest rates might affect long duration bonds, REITs and Utilities.
Currency volatility might affect any foreign holdings that are unhedged.
Recessions would affect the junk bonds and equities of the country being affected.
A global recession would hit both equities and high-yield bonds everywhere.
Etc, etc.

Just because you own an ETF, that doesn't mean that you no longer have any risks. I have met many people that tell me "ETFs are the best since they are very safe because all the risks are diversified away, right?". Too many people worship ETFs these days. They are GREAT and AWESOME, but they are not perfect, which many "followers" fail to point out.

It has been shown (mathematical theory) and proven (real world examples) that diversification need not be 500 different companies to reap the "diversification benefit". In fact, based on Jacques Lussier's book, "Successful Investing is a Process", he illustrates in a graph that diversification bonus exponentially decreases with more securities added into the portfolio. In other words, diminishing returns. Equally weighted, 2 assets give 50% of the bonus. 4 assets give 75% of the bonus. 7 assets give just over 85% of the bonus. 12 assets is about 90% of the bonus. And how much is this diversification bonus worth? According to this thread by on Bogleheads, it is about 0.5% - 1.5% in the long run as mentioned by Rick Ferri. I am still in the midst of reading his asset allocation book, but I have yet to come across that number, so don't take it as factual.

Example of Rick Ferri's 60/40 portfolio


To me, asset allocation is a very specific kind of diversification. Asset allocation diversifies the risks that affects specific asset classes. By having asset allocation (which means, by default, minimum of 2 asset classes), what the investor is doing is actively deciding how much does he want to be exposed to each risk factor that an asset class might expose him to.

Mebane Faber just came out with a new post in reference to much of the research that he has personally done in asset allocation. One of the things that struck me is his final sentences.
As you can see, they all performed pretty similarly. People spend countless hours refining their beta allocation, but for buy and hold, these allocations were all within 200 basis points of each other! 
A rule of thumb we talked about in our book is that over the long term, Sharpe Ratios cluster around 0.2 for asset classes, and 0.4 – 0.6 for asset allocations. You need to be tactical or active to get above that. 
Now, where did he get the sharpe ratios of 0.4 - 0.6 for asset allocations? From his previous research, but here is the table:


Perhaps only quants might appreciate this, but I find it quite comforting to know that pretty much any strategy that uses asset allocation does relatively well in the longer run.

However, are you just happy with a pure asset allocation strategy? Many people do not even know more than 4 asset classes or how to get exposure into these asset classes, let alone the discipline required to monitor, rebalance and inject in capital in an efficient manner. On top of these issues, its human nature to try and be above average. I am no exception. Although I have left the large chunk of my portfolio to a basic asset allocation strategy, I still run a small active portfolio of local stocks to practice my "stock picking".

At the end of the day, the debate between passive and active will never cease to end. Just know that statistically, passive investors that STICK to an asset allocation plan generally outperforms the active investor. Why? I reckon its because of diversification and not having concentrated holdings.

4 comments:

  1. Hi GMGH,

    Great post! It's rare to see our local bloggers talk about this. Passive investors should be made aware of the correlation between assets class. However like rick ferrario points out, some tends to change over time. E.g reit. http://www.forbes.com/sites/rickferri/2014/01/07/reits-and-your-portfolio/

    So in the end, passive investing is not really passive Imo. The important thing is to stay steadfast and stick to the plan.

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    1. Hi Maximillian,

      Thanks for the encouragement!

      Yes, passive investors must still make active decisions regarding:
      1) asset allocation
      2) rebalancing system / capital injection system
      3) investment vehicle (benchmark!!)

      Although I understand the effects of correlation, I don't actually use any numbers when it comes to portfolio construction. Instead I just try to be more aware why certain asset classes are more correlated to others, in terms of shared risk factors. I try to make sure exposure to each factor isn't too overwhelming. How do you make use of correlations and their changing value?

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  2. thanks for linking mate.
    i agree asset allocation is a subset of diversification. Let's imagine hypothetical portfolios.
    1) a diversified equity-only portfolio of irrelevant blend of S&P500, FTSE100, HSI, SPI, STI etc stocks
    2) a long Nikkei long yen portfolio
    3) a portfolio of crude oil, Blumont, and aussie dollar

    They are all diversified. And 3 has the best asset class risk diversification. But 3 will probably drive its portfolio owner to suicide first. And typically, 3 is the kind of portfolio that is assembled by active trading.

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    1. Hi Ladykiller,

      No problem, I enjoy your posts!

      Yikes, yes, although P3 has asset class diversification, they also suffer the full brunt of unsystematic risks! Very good contrast example to P1 where you have a diversified global equity portfolio. I shall tweak your hypothetical portfolios and use it as an example case study when explaining to my friends about risk diversification, thank you!

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