We all investors try and maintain a diversified asset allocation in our investments. In my discussions with many folks, I have seen that many use different ways of executing this diversification. Many use combination of real estate, equities, gold, etc. In case of equities, quite a few enterprising ones long term portfolio in combination with trading portfolio. Many of us, including me, are aware of different types of asset class and investment vehicles. Unfortunately, for most of us individual investors, we fail to understand how to execute effectively. We really do not know how to engineer our portfolio such that it has optimum asset allocation for our risk profile. We think we allocate little bit of capital to all assets and we should be good to go without any worries.
Theoretically, asset allocation is a risk management methodology which depends upon relationship between expected return and risk. In last five year (or more perhaps?), David Swensen and Mohammed El-Erian have shown how this is executed. For starter’s David Swensen is portfolio manager at Yale’s Endowment Fund while El-Erian managed Harvard’s Endowment Fund. The reason I looked at these two portfolio is because, both of these funds, provide more than a one billion US Dollar to university for operating expenses. These funds are managed for cash flow and capital appreciation.
I am looking at Swensen’s work with Yale Endowment Fund (source). This is a US based institutional fund, therefore, may not have a direct bearing on any Indian individual investors. I am including it in this discussion to highlight how the fund’s asset allocation is managed by using ‘expected real return’ and ‘standard deviation of the returns’. Real Return here means over an above inflation. The table below shows the different asset classes with expected real return and standard deviations.
- Every asset class has its own expected return and its corresponding standard deviation.
- Every asset class has a varying capital allocation level
- Every asset class has a very high degree of volatility. For example, domestic equity has 6% expected real return, while its standard deviation is 20%. Same way, private equity has 11.2% expected real return, and its standard deviation is 27.7%. In both cases, the manager expects that there will high volatility.
The interesting point in this asset allocation methodology is the use of concept of expected return. The fund manager projects upfront what would be expected return and how much volatility is expected.
How many of us attempt to project our expected return in a realistic way? When we make an investment (note: not trading), how many of us do it expecting certain level of volatility?
In all my stock analysis, I use expected beta-based return to understand or project my expected return over 8 to 10 years time frame. Based on last 10 years, the expected yearly return from NIFTY is 15.5% (including inflation) while standard deviation is 29%. If we consider an average inflation of 5%, the expected real return comes to around 10.5% for equities.
The message I am trying to convey is, blindly allocating your assets and hoping it safe guards against risk, is a folly. A true asset allocation is based on any asset’s expected return and understanding its volatility/risk.
David Swensen, expected returns, risk management, Yale Endowment Fund