Thursday, April 19, 2007

Asset Allocation

As a seasoned value investor (for those who have been following this blog, hopefully you have become one), asset allocation is a must-know.

Remember we talked about portfolio theory, Markowitz, efficient frontier and the kind of crap. Umm well, actually not that crappy, got win Nobel Prize one, don't pray pray ok. For those blur, read this post. Now in order to earn a return that is on the efficient frontier, meaning the portfolio is so efficient whatever you put in goes straight into your bank account x 10% and then gets immediate giroed to pay your credit card bills.

No, to earn a return on the efficient frontier means that this return can be earned with the least risk possible. Say if you target 10% return, but your portfolio risk is 25% while the risk of a portfolio on the efficient frontier is only 15%, then you loogie big time, bcos your portfolio is not efficient at all and you should really go put some oil on your money to make it run smoothly or something.

So how do we make our portfolio efficient? The answer lies in asset allocation. Asset allocation simply means determining how much to put in different asset classes such that the risk and return will be optimal, i.e. the portfolio is on the efficient frontier.

Back in the good old days when we have only 3 asset classes, the classic answer is 50% stocks, 40% bonds and 10% cash or some similar variation, say 60% stocks, 30% bonds and 10% cash etc. But today, we have 10,000 asset classes, so things are not so simple anymore. An efficient portfolio probably looks like this

40% stocks
10% bonds
10% hedge funds
10% real estate
5% private equity/venture capital
5% commodities
5% gold
5% cash

For a more scientific asset allocation, go google for Havard Endowment’s asset allocation, and you can see how the pros do it. If you want to be better then on top of the above mentioned asset classes, maybe you should consider adding

1% art and antique
1% wine and coke bottles
1% watches and diamond rings
1% krisflyer miles
1% adopted chinese brilliant kids
1% securitized future cashflow from this blog

Ok that’s just for fun hor, don’t follow blindly. The point that is being illustrated here is that current wisdom advocates finding more asset classes that are uncorrelated and then putting some portion of your portfolio in them. (This post has more info). The truth is for the retail investor, finding exposure to asset classes other than equities, bonds and real estate is actually not that easy. Most hedge funds and private equity funds will not accept retail money. But I always believe that when there is a will, there is a way. If you think you really want a well diversified portfolio then you will find ways to do it. Next post of a typical asset allocation for a Singaporean household, watch this space!

See also Efficient Market Hypothesis