Your asset allocation guide – November

In conservative portfolios, the smaller share holding carries the full weight of risk in the portfolio, as opposed to cash and bond components. We discuss how to build robust portfolios for risk-averse investors.

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Asset allocation – the tail wagging the dog for risk-averse investors

Exposure to equity market risk poses an ongoing challenge for professionals trying to build robust, conservative portfolios for risk-averse investors – so what’s the optimum asset allocation for this type of investor?

More conservatively-positioned portfolios, which may comprise 30% exposure to growth assets – usually shares – and a 70% holding in fixed income and cash assets have about 85-90% of their total risk coming from the exposure to shares. In other words the tail is wagging the dog – the small holding in shares is providing almost all of the risk in the portfolio.

How can this be? Depending on the share market and time period we are talking about, the volatility in share returns is around 15% per annum. Some markets are more volatile, like emerging markets, and some periods exhibit higher or lower volatility than others. In contrast, bonds have an annual volatility of around 3% and cash is around 0.5%, levels which have remained fairly constant over time and across markets. So with shares exposing the portfolio to five times more volatility, we can see why most of the risk in the portfolio is derived from shares, even when they represent such a small position.

There are various options for building robust, conservative portfolios for risk-averse investors.

Reduce equities exposure – one option is to hold a smaller exposure to equities or even zero, however, then the portfolio is less diversified and the returns are likely to be very low.

Replace equities with alternative high yield asset classes – another option is to replace equities with alternative asset classes such as high yield bonds, hedge fund strategies and commercial property, but these usually involve less liquidity and the more complex nature of these investments is not always palatable to risk-averse investors.

Consider risk-parity strategies – another solution is implementing risk parity strategies to dial-up the total exposure to fixed income, so that instead of being 70% of the portfolio, the fixed income exposure is increased to 250% through the use of leverage or derivatives such as bond futures contracts. However, although risk parity portfolio better balances risk to 50% fixed income risk and 50% equity risk, the total risk of the portfolio is increased and the strategy may underperform if interest rates rise off record lows.

Ultimately, there is no single solution for portfolio constructors but there is increased research into finding ways to reduce the dominance of equity risk in more conservative portfolios.

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