Addressing the temporal conundrum of asset allocation

Asset allocation could simply refer to the process of dividing a financial or investment portfolio between different asset classes. It’s done to balance risk and reward by apportioning a portfolio’s assets according to an investor’s goals. Technically, the allocation is pooling together assets with limited or no correlation.

Why this matters? It charts out different risk profile and returns journey for each of these assets. This helps in not only reducing the risk but respond to market vagaries differently by each asset.

The very exercise of portfolio creation begins with diversification of various asset classes. Diversification is usually done keeping in mind the goals and their timelines - thus for shorter time horizons, a higher or all the proportion of allocation moves to a risk averse investment and vice versa.

However, another important consideration that can’t be discounted is the risk appetite of the investor. It defines whether an investment avenue must be considered at the first place, as this drives the investor behavior. It allows for the preference of investments to be done in an investor’s portfolio. Interestingly Cullen Roche, the author of “your perfect portfolio’, argues that asset allocation is a temporal conundrum.

We all navigate our ability to consume across time, and we need our portfolios to accrue value accordingly, he says, makes us difficult to manage it. The central theme of his argument arises from the fact that we’ve money today, but our needs are spread across different points in the future and matching these two is harder than it looks. Hence, time is the crucial problem for any financial planning to solve.

Most of our liabilities tend to have fixed temporal constraints. For instance, a fixed monthly EMI or a periodic credit card due, etc. We’ve all these liabilities that we must meet across specific time horizons. Good financial planning means matching across time with these liabilities to meet the desired goals. So, the asset-liability mismatch happens as the assets are flexible and could be fixed in time while the liabilities (goals, expenses) are often time-bound.

A prolonged period of nil or negligible returns like the equity returns in the last 18 months and/or a sudden dip due to the recent conflict could not only jeopardise the investor’s returns but hugely expose this asset-liability mismatch. It means that the portfolio doesn’t have enough security in the portfolio to withstand the volatility, due to this mismatched asset allocations.

This is particularly true when planning for long-term goals like retirement. The sequence of return risk is the danger that the market downturns occur early in retirement while making withdrawals, causing permanent depletion of the portfolio.

This could be countered by asset allocation and partly through bucket strategy. So, Roche argues in his book that true diversification should be understood not just as asset allocation but as temporal diversification as well. It means that benefiting from being diversified across assets with different time horizons.

So, he turns the head on diversification stating that the allocation shouldn’t be done only through the traditional understanding of correlation amongst the assets alone but across time horizons. When working, your income acts like a fixed-income asset as it generates predictable money over time. This gives the young investors more ‘implicit’ safe allocation letting them take more risk with stocks.

The allocation that works when young doesn’t work to the aged, as the time horizons and liabilities change in retirement. At retirement. the need for short term certainty is high and thus the limited exposure to stock volatility. Revoking Ken French’s definition, risk equals uncertainty of future consumption i.e., risk isn’t just volatility but the chance you can’t meet your spending goals when they happen.

It’s easy to comprehend bonds as they generate predictable cashflows. Roche also suggests that thinking stocks as a 30-yr bond, where the odds of losing money over a 30-yr period is low but it wouldn’t be appropriate to fit this allocation into a 3-yr liability bucket. Most investors are behaviorally biased and short term oriented.

This behavioral danger of short-termism leads us to act on every news or info, increasing the costs to spike adding to the underperformance.

Roche opines that the asset-liability mismatch could be addressed by structuring the portfolio so that each layer of the assets corresponds to a specific future need or time horizons. It’s important also to stop thinking returns in the abstract and instead match each block of savings to the time horizon of the need it’s meant to help.

In conclusion,the asset allocation isn’t just about spreading money across bonds, equity, etc. but it’d fundamentally about matching assets to the time.

(The author is a partner with “Wealocity Analytics”, a SEBI registered Research Analyst and could be reached at [email protected])