The Asset Allocator dials down Risk, Should you?

The simplest and the best asset allocation matrix is not one that brings the greatest benefits but one that you can stick through the thick and the thin. In popular parlance, a 60:40 split between Equity and Debt is the best split you can ever have. All you need to do is once a year or once in two years adjust for any changes to bring the ratio back to 60:40 and voila, you are all good.

The thought process is that having 60% exposure to equity will add value in the upside while the 40% exposure to Debt will ensure a steady boat that is not rocked by turbulence the way a 100% equity allocation will.

Unfortunately, the 60:40 split suffers from the fact that while exposure of Equity is limited to 60%, its volatility is much higher making it seem more like a 80:20 or even a 90:10 portfolio. As I showcased in the previous post (The Surging Balanced Funds – The Good, Bad and the Ugly), Balance funds which implement the idea of such a split have hurdles that aren’t easily to overlook.

In out and out bull markets, Balance funds massively under-perform the Equity funds (CAGR for last 5 years for the Best Equity fund is 32% while its 20% for the Best Balanced Fund) while in a deep swirling bear market; they aren’t too different from what you could have expected from a Equity fund (Drop from peak in % terms). Hence, while you miss on the upside, you more or less are forced to partake the gifts on the lower end.

I have been on this site posting a split for Equity and Debt based on your Risk Profile / Time Horizon (Greater the time available, more aggressive you can afford to be) for quite some time now. This is a contrarian way of approaching investing with risk constantly being removed as markets creep higher without accompanying growth in the companies that represent the market while adding Risk when rest of the market is panicking.

The contrarian attitude of the model cannot be showcased better than what happened in May 2016. At the end of May, the Model started to cut exposure to Equity. But my own indicators were suggesting that rather than dial down exposure, we should add to it since we seemed to be ready for a bull run in the offing (Start of a New Bull Market?)

Yesterday, the model once again dialed down Risk to the lowest since May 2015 when I started posting the model. Yet, just a couple of week back, my own reading of the market seemed to suggest that we may be in for a Melt up rather than a Meltdown as many were suggesting (Fear of Meltdowns and Power of Meltup’s).

This is bound to be confusing since if a strong move higher is coming, now is the worst time to cut down on risk. As much as its horrible to see portfolio’s decline day on day, it’s even tougher mentally to stay tuned to a lower risk profile when every Tom, Dick and Harry seems to be reaping the rewards of the market.

The way the Asset Allocator has been build is not to try and predict future returns but rather try to remove risk as the same gets build up. Currently, based on the inputs the model uses, its indicating that Risk is at a very high level.

On the other hand, the reality is that markets can remain oversold or overbought for more period of time than what we are prepared for. The question that crops-up is, should be really dial down exposure when there is no sign of turbulence on the horizon.

The way I love to build portfolio is to split it into Permanent or Core Holding and Opportunity based Holding. The permanent holding can be mutual funds (both Equity and ELSS) which you are comfortable holding through the up and down and are not looking at it as savings for any objective that isn’t at least 10 years away.

The Opportunity based Holding on the other hand can be based on either Momentum or Value. For my personal portfolio, I have chosen Momentum while for family portfolio’s I manage; I have tried to create a mix of Value and Momentum.

On the value front, I am loaded up on sectors like Pharma and IT. Yes, these aren’t the sector that are to be touched with a barge pole, but for me, by having a exposure to these sectors I hope to have a lower portfolio risk even though the asset allocation maybe well over what is recommended at the current juncture.

Momentum on the other hand is plain and simple. I stay long in stocks that are showing strong momentum and churn the portfolio once a month to weed out the ones that are showing signs of weakness (real weakness or relative weakness).

While the Risk is way higher, the model has an exit clause which when triggered will allow me to cut exposure from 100 to Zero. The risk then is all about how much damage the portfolio will sustain before risk is dialled down to Zero.

The Asset Allocation model I post is not a recommendation but to be used as a input on the current state of the market. While you may feel confident about the future, remember that the path isn’t as smooth as we think it will be.

The key to the best allocation mix is to think deep about how much of a pain (marked to market loss or draw-down from peak) you can absorb and still sleep well at night. Whatever number you can think of, reduce it by 50% for dream and reality can be way different in how we react to the event.

Personally, my own current asset allocation mix is 40:60 (Equity:Debt) and this is a ratio I am willing to maintain for the foreseeable future. What level you should maintain depends on a host of factors that are unique to you and no automated calculator can come up with a mix that is optimal to you.