Risk-based Asset Allocation

October 22, 2012

Any investment advice starts with asset allocation, which simply means spreading our investments across various asset classes with a view to diversifying our risks. Sounds complicated isn’t?

 

It is frequently suggested that as investors we should invest across various asset classes i.e., equities, bonds, real estate, hedge funds, etc. I am not so sure if investors with non-investment background can really understand and appreciate the nuances and differences between various categories of asset classes. Even if they understand the difference between say equities and bonds, how frequently can they make an intelligent choice of these investments and how well they can view their overall investments in terms of asset allocation is still a question, at least to me.

 

I am proposing something that may be different from the classical asset allocation theories.

Before I recommend the idea, let us aim to draft the purpose of investing our surplus. To me, investments should

  • be age agnostic

  • be treated as a flow than a stock

  • let you sleep well at night

  • never result in capital erosion and

  • take care of us in old age

 

Two of the above 5 points need a little elaboration while the other 3 is self-explanatory.

 

Age Agnostic

 

Many a times, we are advised that we should be aggressive in our investment during our young age and should be conservative during our middle and old age. In other words, we should be risk seeking during our young age and risk averse during our old age. While this has its merits, it normally does not happen that way. The concept of ability to understand risk is ignored here. At young age, we may not have sufficient knowledge and experience to understand the risk inherent in an investment. Alternatively, as we age with experience we are more capable of appreciating what a true risk is. Also, we normally tend to invest our surplus. Surplus generation happens all through our life span and hence investment decisions have to be made even at old age as much as young age. In fact, the surplus tends to be less during young age as we are busy buying capital goods and incurring set-up costs.

 

Flow than a Stock

 

Since surplus flows every month (at least for salaried people), investments should be viewed as a flow. In other words, occasional decisions on where to invest should not be the case since surplus keeps accruing. However, traditional asset allocation assumes that our wealth is a stock rather than a flow. 

 

Given this understanding and background of what should be the purpose, the question now shifts to how to deploy this surplus. When we encounter an investment opportunity, we have three scenarios i.e.,

 

  • We are familiar with it and we fully understand what it is (say fixed deposit)

  • We are partly familiar with it and we have difficulty in understanding what it is (say            midcaps!)

  • We are totally unfamiliar with it and have no clue what it is (say managed futures!)

Let me call the first category as “Easy Bets”, the second as “Tough Bets” and the third category as “Wild bets”. The irony is that we do not end up always investing only in easy bets. Many a times we do investment in tough bets and wild bets based on advice tendered by friends/relatives and other associates only to rue such decisions later in life. Here is a list of many investment opportunities classified as per the methodology:

 

 

How do we make this classification? Whenever, we receive/view an opportunity we should put them in the following frame of simple analysis: 

 

1. Probability of loss: In my view, this is the true definition of risk. Easy bets are those where            probability of loss is close to zero.

 

2.  Liquidity: Investments should be reasonably liquid, if not they only have paper value and not       realizable value. Easy bet investments are normally highly liquid.

 

3. Transparency: The opportunity should be easy and simple to understand even to a layman.          Avoid structured products as even professionals do not understand them!

 

4. Familiarity: The investments should be familiar and hence reduces your anxiety of                       investments. A Brazilian stock may be familiar to Brazilians but not to an Indian! Risk is a            perception purely based on familiarity. For eg., if you are a currency trader, then exotic              currency investments will become easy bet rather than wild bet!

 

The Strategy

 

The idea of this paper is not to suggest that you invest all your money only in safe bets. Predominantly you should be investing in safe bets (say 60% of your investible surplus). However, in search of higher returns, you should allocate some money towards tough bets (say 30%) and a small amount to wild bets (say 10%). The rationale behind wild bets can best be explained through an analogy that says “pulling the mountain through a hair. If lucky you get the mountain, if not the loss is just the hair!”. Take exotic currencies as an example. Iraqi Dinar is a good example. In the 1980’s, one Iraqi dinar bought 3 US dollars. Today one USD fetches 1,165 Iraqi dinars! Can you imagine? Iraq still possess huge oil reserves and can turn around like how South Korea and Italy did. If that happens in the next 20 years, imagine the payoffs. No wonder Americans are busy buying millions of Iraqi dinars and storing them in  their lockers and pillows. Wild bets have this characteristics. If they pay off, they pay off big-time. If not, you will lose all your money. Hence, such investments should never be more than 10% of your investible wealth.

 

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