In Part 1 of this documentary, practitioners discuss the growing role, importance and integration of asset allocation & behavioural finance to create robust portfolios.
Date: Sept 2010
The value of diversified portfolios
Given that there have been three significant financial market crises in the last 13 years – the Asian financial crisis, the tech bubble and the recent financial crisis – Leonardo Drago, chief investment officer at AL Wealth Partners in Singapore, hopes that investors have learned that being 100% in equities is not a good thing.
The only way to avoid suffering too much during such times is to properly diversify a portfolio, he said.
Diversification is a key, proven tool for investors, added Robert Cormie, managing director of CIBC Private Wealth Management in Asia, explaining that the more they diversify, the more they can reduce risk and increase returns.
Investors who put everything into a property in China, for example, might do well over a 10-year period, but they might be taking undue risk of the markets turning and having a significant impact on the overall portfolio.
When it comes to individual asset classes, Asian investors don’t like bonds as they think they are too slow and they don’t really understand hedge funds, explained Drago. Instead, they like equities and they like property, because they can leverage these assets and potentially see big returns in a short space of time.
Many clients do have a bias to invest in the areas where they are located, know the names and are therefore comfortable putting their money, said Cormie.
However, he advised, if they diversify beyond that, they might be able to take lower risk and possibly get the same, or even higher, potential returns over that period of time.
Drago said he sees big differences between the performances of the portfolios of his Asian and European clients – noteworthy is that the European clients are much more conservative yet make more money.
This is largely because a lot of wealth in Asia is mainly new money, he explained, and the first generation generally wants to be more hands on.
In Europe and the US, however, where the wealth is now in the hands of the second, third and fourth generations, they better understand the value of conserving capital first and then looking at returns later.
According to Marc Van de Walle, managing director and head of product management at Bank of Singapore, a sensible approach when advising clients on their portfolio strategy is to divide the proposal into a core and satellite offering.
The core part, which depending on a client’s risk profile, Van de Walle said he thinks should be between 70% and 90% of a total portfolio, should be made of traditional asset classes such as stocks, bonds and cash.
In Drago’s view, diversified portfolios should include all the major asset classes. One asset class which investors are only now starting to look at as part of a diversified portfolio, and one which should definitely be included, he said, is commodities.
In terms of equities, investors need to be careful about their allocations, he warned. For example, too many people are now overweight emerging market equities at the expense of the US and Europe.
Drago said he thinks this is a mistake, as investors tend to chase performance based on what has done best in the last one to three years. However, in general, he said that the best performers over the last five years are unlikely to do as well in the next five years.
Van de Walle said the value of core-satellite portfolios can be found in the fact that if investors want to invest in risky assets, they should take a long term view – at least five years as a minimum.
So the purpose of the core part of the portfolio, he explained, is to help investors focus on the long term and fulfill their goals over that timeframe.
Many historical studies have shown that as long as people get their risk profile correct, they can bear the risk, explained Cormie.
If an investor has taken an appropriate amount of risk and has the capital required, it is possible to ride out volatile market situations to the investor’s benefit, he said. The problem, said Cormie, is that some people take heightened risk during bullish markets, and not enough risk during bearish markets.
The challenge therefore comes when investors put more capital at risk than they wanted to – at that point, if they lose 20% to 30%, they will likely need to change their allocation to give them enough money to live on. In these types of situations, it becomes clear that the investor didn’t create the proper portfolio at the outset to determine what kind of investments to get into.
Given that Asian investors tend to be focused on the short term, Van de Walle said that to demonstrate the value of taking a longer term view, advisers can show clients the benefits of riding the cyclicality of the market.
Indeed, said Cormie, the wild markets seen throughout the financial crisis showed just how difficult it is to time the market and do tactical asset allocation every six months based on where investors and advisers think the market is heading.
Advisers and investors need to be aware that asset allocation is just as valuable in a highly-volatile environment as it is in a more stable and less stressful environment, he said.
Approaching asset allocation
According to Mark George, director and authorised representative at Australian-based independent advisory firm Positive Financial Solutions, the key thing for advisers to do is get asset allocation working in line with what an individual wants to achieve.
This means going back to basics and looking how much an individual can invest each year and where they want to get to – and therefore what returns per annum they need to achieve. From there, advisers can then look at the likely asset allocation to meet these goals, he said.
However, he warned, the test is to ask clients how they would feel if, for example, they create a portfolio comprising 70% growth assets and 30% defensive assets, and then markets drop 50% in one year.
When advisers create a portfolio for a client, added Cormie, that they should back-test it to look at the best and worst years, and the best and worst quarters. They are then in a better position to discuss this with the client.
Advisers should be asking their clients if they are willing to lose “x%” of their portfolio over a certain period of time, he said. The client’s answers will determine whether certain investments are suitable and whether the client has the right asset allocation.
Advisers can then adjust the portfolio accordingly, said George, deciding whether take a more defensive approach, or take on a bit more risk.
This shows how crucial asset allocation is when setting up a portfolio, he added, especially since most people don’t know what is going to happen in the markets, regardless of what they say they know.
However, since diversification wasn’t seen during the crisis to work as well as people expected, Van de Walle said there has been a move away from asset allocation in terms of asset classes in favour of getting exposure to different types of risks.
People are therefore trying to decompose stocks and bonds, for example, into different risk buckets to do their allocation accordingly, he explained.
At the same time, he said this is difficult to implement in the private banking model. While it is effective for large institutional investors, it is less practical for individual clients.
Van de Walle said he therefore prefers to stick to a more traditional asset allocation strategy, using models as a basis to calculate ideal weightings of assets initially, and then using judgement by taking into account different risk factors.
Another important point about ensuring a proper asset allocation is the need to rebalance, said Drago, whether once or twice every year. Investors need to sell winners and put more money into those assets which have fallen to ensure they are never over-exposed to an asset which has peaked.
The influence of behavioural finance
With the increasing affluence in Asia, in turn giving people a richer array of more complex choices for investing, behavioural research has become ever-more relevant in wealth management, according to Arun Abey, chairman of ipac Securities.
For instance, he explained, the new “sandwich generation” is seeing its parents live longer and with more health-related options, which are costly. At the same time, the children of this generation have higher – and more expensive – aspirations in terms of their upbringing.
There is, therefore, a real need to plan and understand the associated behavioural issues, said Abey.
At the same time, most Asian investors don’t realise that the more money they have, the more important it is for them to conserve that capital rather than keep shooting for 20% to 30% annualised returns, said Drago.
The main question that behavioural research is trying to answer, said Abey, is why people make the decisions they do? And how do they make these decisions, given the complexity and uncertainty of investing?
According to Abey, financial research shows that most people are not well-placed to make good money decisions. Some of the key behavioural biases involve the fact that an individual’s orientation is inherently short term rather than thinking long term.
According to Van de Walle, a big challenge in Asia is to deal with the transactional approach that so many clients take towards their portfolios.
This happens, he said, because people tend to invest money in the same way as they made it – which in Asia means taking big and concentrated bets.
Changing this mindset comes down to education about the value of preserving wealth. Relationship managers (RMs) and other advisers therefore need to spend a lot more time helping clients define their portfolio goals, he explained.
For example, he said, rather than answer specific questions from clients about where to invest their money, RMs should look instead at the risk profile of the client to determine what is best.
According to Abey, Asia’s wealth management industry must avoid the mistakes made in the West.
For example, he explained, whereas in countries like the US, Australia and the UK there has been a tripling in wealth since the Second World War, measured happiness remains unchanged and there are record levels of stress, anxiety and depression. Perhaps most worrying, he added, is the tripling in the youth suicide rate over the last 60 years in almost every Western country.
This doesn’t mean that affluence is bad, he said, rather that it doesn’t automatically translate to well-being.
As a result, as Asia comes up the curve in terms of affluence, it should draw on behavioural research to link money to well-being.
Effective advice to create sound portfolios
According to George, there are a large amount of distractions in the markets, for example through the media and other forms of communication about trends, creating a roller-coaster for clients.
For advisers, they need to first determine whether their model is focused on buying and selling stocks, or whether they are asset class-focused, offering more of a strategic weighting approach.
These are different styles, said George, and require different approaches in the way advisers should then educate clients and handle their emotions in relation to how hands on they need to be.
Abey said there are four key principles on which advisers should build client portfolios: first, including quality assets which have a prospect of producing a profit; secondly, ensuring the asset prices are sensible; thirdly, recognising that even with the best research mistakes can still be made, making diversification key; and fourthly, having time and patience.
This is all easy to say, he acknowledged, but it is hard to do in practice.
In general, added George, investors do not like to lose money, but they get greedy in boom markets as they do not like to miss out on any opportunities.
It is hard therefore for advisers to deal with these emotions and be prepared for clients to question the advice they are given. Clients’ emotions mean they often forget the original intentions of why they chose to follow a particular strategy in the first place. So it is important to make the objectives clear from the outset to avoid problems later on, said George.
According to Abey, advisers who want to do the right thing by their clients often need to realise that they must give up some revenue in the short-term.
In the midst of bubbles or fear, it is hard to overcome investor biases, but winning the trust of clients can help to achieve that, he said.
The key to being able to convince clients of that, said Drago, is being able to show them good alternatives. Yet most RMs in a private bank don’t have access to those alternatives; they can show clients their institution’s balanced portfolio, but in 2008 these fell significantly, leading to clients questioning their value.
To win a client’s trust, advisers need to put portfolios into a broader context, said Abey. This can be done by discovering what is important to clients in their lives. Most financial training is technical, but engaging an individual in terms of what is important to them in their life is not straightforward – it is driven by a person’s core values, priorities and aspirations, which are often developed in childhood, he explained.
Financial advice focuses too much on doing a plan for the money, said Abey. Typical fact-finders in the planning process look at an individual’s material goals, but advisers need to go beyond this, he said, and understand the emotions behind the material goals.
It is often the case that people then come up with a new sense of what is important to them.