It has been a volatile few years for the global markets. Pummeled by the COVID-19 pandemic, risk assets endured a fierce selloff in the 1Q2020 as economic activities came to a grinding halt with a complete shuttering of businesses. Global equities succumbed to one of the steepest and quickest correction ever witnessed in March 2020.
However as sharp and quick as the rout began, the recovery has also been swift and ebullient. Due to unprecedented stimulus measures injected by governments and central banks, benchmark gauges have rebounded strongly driven by ample liquidity. The US stock market has even surpassed its pre-COVID-19 peak despite infections continuing to rise in the country.
To any casual market observer, the new normal investment realm can be confusing terrain to navigate as the gap between the real economy and the stock market continues to widen. This is especially as traditional macroeconomic theories no longer apply in a world of negative interest rates and unlimited quantitative easing (QE).
Whilst the markets will ebb and flow, it is far more important for investors to stay the course and practice diversification in their portfolios. Here is a 5-step guide that investors can follow to an effective asset allocation.
Step 1: Defining Your Investment Objectives
It’s the first step in the asset allocation process that often gets overlooked. But really, it is the most important part that you should invest the most time with before modelling a portfolio.
Asking yourself basic questions like “who am I?” and “what are my aspirations and expectations?” can help you define your objectives. Are you a millennial looking to build and accumulate wealth, or are you someone in your mid-50s looking to prepare for retirement and have a steady income stream?
Once you’ve established these answers, it’s crucial then to be as specific as possible and to be able to quantify your financial objectives. How much wealth do you want to build exactly? How much does your current lifestyle cost and how much do you need to sustain it?
For example, someone in their mid-50s will need to determine how much wealth they would like to accumulate by the time they reach retirement, as well as the rate of return % they need to achieve as a hedge against inflation.
All these considerations are important because it lays down the parameters of your investment objectives so that your portfolio is geared towards achieving its stated purpose.
Step 2: Gauging Your Risk-Tolerance
Determining your risk-tolerance is the next step. Understanding your risk-tolerance can also be gauged by asking yourself basic questions like your age, monthly income and expenditure and other types of commitments you have. Different psychological profiles and imprints often determine what type of person you are and if you are a risk-taker or risk-averse.
But it is critical here to separate what your risk-tolerance and risk-acceptance are, as the two gauges measure different things. For example, an investor in their mid-20s may be more inclined to take on more risk because of his youthful exuberance and more daring nature. Therefore, he has a high risk-acceptance.
But if you consider the fact that if he is already married with a child along the way, as well as parents and in-laws to take care of, his capacity to take on risk is actually limited. As such, the investor actually has a low risk-tolerance and would not be able to stomach an aggressive portfolio that is highly tilted towards riskier asset classes.
Step 3: Time Horizon and Liquidity Needs
Next, an investor would need to determine their investment time horizon and liquidity constraints. Think of these two factors as the levers shifting the gears of your portfolio that will ultimately determine your capacity to invest and by how much.
For instance, an investor in their mid-20s who does not need the principal sum and returns back from the investment for the next 8 – 10 years would have a long investment horizon and hence a higher capacity to invest.
This would allow the investor to take on more risk and be more exposed towards longer-dated instruments or riskier asset classes that only show returns at a later stage. Such asset classes typically include small-caps or growth stocks that are high-risk and typically exhibit strong earnings and growth only at a later cycle. Thus, investors with a shorter investment horizon should avoid such asset classes.
Similarly, as an investor you should also assess your liquidity needs and determine how much you are willing to set aside from your wealth as investments. It’s crucial that you understand that this is a separate pool of wealth that is different from your own savings account that you use for your own daily sustenance and allowance.
Thus, as much as possible, you should avoid dipping into either pools of wealth and using your savings for investments and vice-versa.
You need to give time for your portfolio to work and to compound returns. Opting to cash-out from your portfolio can be disruptive to your investments especially at a crucial stage of the market cycle when it is starting to rebound. Thus, investors should remain disciplined and focused.
Step 4: Understanding Different Asset Classes
These are the ‘building blocks’ of your portfolio. There are 3 broad asset classes for an investor to work with, i.e. equities, fixed income and cash.
Equities are the riskiest asset class but has the potential to provide the highest returns. Common instruments include ordinary shares or equity funds that an investor can easily buy into.
Fixed income, also known as debt, is a less risky asset class that provides more stable but often lower returns. Investors may not be able to gain exposure to this asset class by investing in bonds directly or through bond funds.
Cash or cash-equivalents are the most liquid asset class and typically provide little to no returns especially in inflationary periods. But they serve its importance by being extremely liquid to quickly move in and out of a market correction as well as a buffer during an emergency.
There are also other types of asset classes including REITs, commodities, precious metals, real estate or even alternative asset classes such as private equity or debt. But more importantly, you need to really understand what it is that you are investing into and the underlying asset class of the product before deciding to include it in your portfolio.
Step 5: Constructing Your Portfolio
Finally, you are ready to construct your portfolio. There is no single method or approach in building the ‘perfect’ portfolio, as each portfolio would need to be customised according to the needs and risk-profile of the investor. But there are some model blueprints that an investor can follow as a start.
For more risk-inclined investors, they can invest in a more aggressive portfolio composed of 70% – 80% in equities and the rest in fixed-income. On the flip-side a more risk-averse investor should have a higher tilt towards fixed-income of between 70% – 80% in bonds, with minimal holdings in equity and some in cash. A risk-moderate investor could have equal exposure to both asset classes.
Underpinning all these considerations in the asset allocation process is the simple principle of diversification of not putting all your eggs in a single basket. Diversification strives to minimise risk in a portfolio by investing in a mix of different types of asset class that are not or less correlated, so that gains from one asset class can offset losses from another.
It is a risk mitigation technique that has been proven to outperform over the long-run by protecting against losses, whilst maintaining sufficient exposure to capture market growth.
Knowing is Half the Battle
Starting your investment journey can be especially daunting during such volatile market conditions. But as the saying goes, “Never let a good crisis go to waste.” Anyone can invest as long as you have a plan and a robust asset allocation to ride through the market peaks and troughs.
About the Author
Lee Sheung Un is a communications officer at Affin Hwang Asset Management. A millennial, he is still finding that balance between wealth, freedom and purpose. Views expressed are his own.