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Everybody knows the importance of asset allocation. But what exactly does it mean to get asset allocation right? The best asset allocation is the one that provides the highest return, but hindsight is 20/20. We know how difficult successful tactical asset allocation is for an individual investor. Holding a little bit of everything, relying on diversification and engaging in strategic asset allocation with the goal to control risk rather than chase returns (a notoriously fruitless exercise) is an alternative.

One aspect is often overlooked in the context of strategic asset allocation. Say an investor is deciding between 60% equities: 40% bonds, and 70% equities: 30% bonds. Investors know that equities are more risky than bonds and that the first asset mix will allow them to sleep better. But here comes the rub: the risk of asset classes themselves changes.

Rebalancing to a fixed asset mix

Let’s say we are in the beginning of the roaring 1990s and we decide (by running asset allocation software, going with a gut feeling or looking at a crystal ball, whichever works) that the asset mix of 60 S&P 500 and 40 bonds is right for us. Being disciplined investors and knowing about the benefits of rebalancing, we religiously rebalance to this fixed mix to ensure that the portfolio remains within our risk tolerance. Eight years later we end up with a perfectly rebalanced portfolio of 60/40. The portfolio still has the same amount of risk as it had in the beginning of the 90s, right?

Wrong.  Looking at the sector composition of the S&P 500 Index, we see that, as of December 31, 1990, the technology sector weight was 8.9%. Ten years later the technology weight was a whopping 28.2%. Given how risky the sector is, intuitively we feel that this changes the overall risk level of the S&P, significantly increasing it. In other words, despite all the rebalancing, we now have a significantly more risky portfolio than the one into which we initially invested.

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Risk changes over time - but is more persistent than returns

This intuitive approach is confirmed by calculating the actual risk of the S&P 500 (as measured by the 252-day rolling standard deviation). At the beginning of 1990, the volatility was approximately 15%. As the technology weight ballooned, the overall S&P 500 volatility increased to 20%.

This simple example illustrates one important fact – risk changes over time, and so should your asset mix (if you want to control downside and sleep well at night). Notice that we are not suggesting chasing performance or timing the markets. But we do recommend watching the market’s pulse and adjusting the proportion of asset classes downwards that are becoming more volatile, whether in bull or bear markets. Similarly you can increase the equity weight during quiet markets. Simply, we suggest timing the risk, rather than return.

The reason you can do this is that the risk is persistent, which means that if markets were volatile in the previous month, they will likely be volatile in the following month and vice versa. One measure of persistence is autocorrelation. The autocorrelation for monthly volatility of the S&P 500 is around 60%; the autocorrelation for monthly returns is close to 0%. Translation: risk is persistent, return is not. The persistence of volatility is the raison d'être for the whole risk modeling industry, an increasingly important part of professional investment management.

Ideally, investors should employ asset allocation with the help of a regularly updated risk model, putting overall portfolio risk in the context of each individual investor’s risk tolerance. For do-it-yourself investors, access to a risk model and the expertise necessary to use it, is often not an option. Alternatively, as a rule of thumb, one could look at the CBOE Volatility Index [VIX] which measures the implied volatility of S&P 500 index options. Persistently higher levels for this index would suggest rebalancing into a slightly more conservative asset mix, perhaps a 5% equity weight reduction. Persistently low levels might indicate that a slight increase in equity weight is sensible.

Worth the effort

In our experience, rebalancing to a constant volatility, as suggested above, yielded 3-4% per annum higher returns than rebalancing to a fixed asset mix (using back-tested data over the last ten years ending December 2007). While actual returns may differ, this is a meaningful difference worthy of every investor’s consideration.

If in the long term risk equals return, focusing on risk management today will pay off in the form of robust returns in the future.

Source: Risk-Based Asset Allocation: Worth the Effort