How to discuss asset allocation

The balance between return and risk is often equated with the trade-off between health and exercise.

While all investors have an appetite for greater wealth (being healthy), they also have a limited tolerance for risk (exercise). Unfortunately, risk is a difficult, often abstract, concept for investors—especially when it comes to investment selection. As a result, risk is usually ignored altogether.

When evaluating the success of an investment plan, the average investor focuses on the end result—performance.

Read: Push for proper asset allocation: Hughes

Yet return is just one factor to be weighed. At least equally important is the risk profile. Consequently, risk allocation can be an even more efficient approach to safeguarding one’s exposure than traditional asset allocation strategies that simply seek to diversify investments over a range of asset areas.

Depending on your risk appetite, utilizing a risk allocation strategy can be a form of insurance against extremes or used as an opportunity to generate outperformance.

Risk is real, whether it is interpreted as the possibility of losing money or the uncertainty associated with achieving a wealth target.

Read: Risk and asset allocation: A client handout

The goal of a risk allocation strategy is to keep portfolio risk at an appropriate level throughout the investment process and to take risk only where it is likely to be compensated with return.

Stay prepared

No discussion about diversification is complete without first touching on one of its basic underpinnings: correlation. Correlation is represented by the correlation coefficient, a numerical measure of the strength and direction of the relationship between two series of data or variables.

Values range between -1 and +1, with a correlation coefficient of +1 indicating that the two variables have a perfect linear relationship. In contrast, a correlation coefficient of -1 shows a perfect inverse linear relationship. A correlation co-efficient of zero suggests that the variables may have no relationship and may be independent.

Read: Is diversification dead?

A basic approach to achieving diversification is to combine asset classes that have low correlation in an effort to limit exposure to any particular sources of risk. The theory behind this approach is asset classes exposed to common risks should exhibit correlation, providing an opportunity to implement a risk allocation strategy to protect or drive end investment plan returns.

Correlation can change over time and should be used as a guide rather than a certainty. Correlation ebbs and flows. There are points in time (such as the period between 1995 and 2001) when the S&P 500 Index far outpaced international markets. And there are other points in time when the opposite was true. Holding both asset classes, rather than only one, has provided a superior result to holding only one or the other. Over extended periods of time, diversification can prove reliable.

Short-term mindset

However, it is fair to conclude that most clients will not want to wait 35 years to measure and realize investing success. During economically difficult times, such as those in recent memory, we have seen asset class correlations move towards +1.

In fact, the increased magnitude of correlations in the last crisis was not unprecedented, even within this time period. It is also worth noting that between those periods of high correlation are periods where correlations were weaker.

Read: Tactical asset allocation

But does this mean that correlation and diversification fail us when we need it the most: during times of crisis and short periods? The answer is no. Conventionally, diversification is achieved by investing in different asset classes. Yet we cannot rely solely on correlation and asset classes to capture complex relationships between investments. Correlation is only going to articulate the average over various states; it does not capture specific events. Yet it is often during these specific shocks when investors are most concerned with their portfolio’s performance.

Take a typical pension plan asset mix:

• 36% Canadian bonds
• 35% Canadian equity
• 14% international equity
• 13% international equity, EAFE
• 2% cash

When viewing it by asset allocation alone, the portfolio looks to be well diversified; most investors would be pleased with the amount of diversification represented. But look at the same portfolio through the lens of risk and we see a different picture. Portfolio risk, as measured by standard deviation, is approximately 9.4%. When reviewing the mix from the perspective of risk allocation, it would appear equities account for 62% of the portfolio, yet are responsible for 96% of the total risk.

What does this mean? If risk drives return, the overarching results are dominated by equity exposure. Once viewed through this risk lens, the portfolio looks far less diversified. A negative shock to equity markets would have a significant effect on this portfolio.

Read: Time for an asset allocation revolution

It would be premature to declare asset allocation a failed investment approach. In fact, asset allocation remains an important factor to consider when constructing a portfolio. But it cannot be considered in isolation of other events at play.

If investors think about investments solely in terms of what asset class they own (e.g., bonds, equities, small cap, large cap, international, etc.) without taking into consideration their exposures to systematic risks such as economic growth, liquidity, interest rates, inflation and political risk, they have less information about what is going to drive that asset in extreme times. In turn, a risk allocation strategy supports their appetite for higher returns while preserving capital.