Chances are most of us have some kind of investment, either in stock, unit trust, or property. For those who have enrolled in employee stock purchase program offered by employers, they probably have a big chunk of their asset in their own company stocks. However, the Enron incident in 2001 should be a wake up call. If you own a lot of your own company stocks through employee stock purchase program, you may want to consider reducing the holding. This is not implying that your company stock will tumble like Enron. We are more concern about risk management of our investment portfolio. We want to protect the hard earned money that we prepare to use during our retirement years.
For those who own a lot of equity funds or stocks, you may also feel uncomfortable with the current market volatility. Should you start to move out your money to somewhere? Is there a safe place to park your hard earned money? For how long should you park your money in a safe instrument and not risk missing out the market up cycle?
All these questions are valid concerns for every serious investor. Before these questions can be answered, let us explore another aspect of investment which often gets neglected by those investors who like to chase upon high-return funds. When the market is booming, the chasing-high-return-fund strategy will almost certainly yield a better return. However, high return funds have higher risk that we must not ignore. The prices can tumble as fast as they went up.
One recent good example is property sector funds. For an example, we take Hwang-DBS Global Property fund (see Chart 1) which was incepted on 19 May 2006. It went up as much as 33% in less than 1 year. However, after peaking in late Feb 2007, the fund started to decline. As of this writing, after almost 2 years since its inception, it is still below its offering price.
Chart 1: Hwang-DBS Global Property fund historical performance.
Another example is China related funds. The Greater China market was so hot, and it is still relatively hot although it has tumbled quite a lot since it peaked in Nov 2007. Chart 2 shows the historical performance of Public China Select fund. The price is still below its offering price as of this writing.
Chart 2: Public China Select Fund historical performance.
Both examples above share a common pattern. The fund prices were performing very well, but once the prices reached a peak, they all tumbled to below the respective offering prices. This happened in a relatively short period of time, i.e. within 1 year and 2 years for Public China Select Fund and Hwang-DBS Global Property Fund respectively.
In a volatile market, like the one we are experiencing, what can we do to reduce the risk and maximize our investment return? If we are able to predict the future market movement accurately, we can time the market and perform fund switching accordingly to maximize our investment return. However, we all aware that it is near to impossible. Recent events such as September, 11 Attacks on 2001, SARS in 2003, Indian Ocean Tsunami of 2004, Subprime mortgage crisis of 2007, were unexpected and caught most people by surprise.
On top of unforeseen circumstances, emotional factor also plays a major role in our decision making process in investment. We may fall in love with certain funds/stocks and reluctant to sell when we are supposed to do so. We may ignore the risk and keep chasing a bubbling market. We may feel reluctant to invest when a bubble has just burst. Why? There are two sentiments in us that determine our decision in investment: Fear and greed. Apart from the market fundamentals, the general public sentiments can add volatility to the market.
A systematic approach to reduce the risk of unforeseen events, and to remove the dependency on our own emotion, is to have an investment portfolio that has proper asset allocation according to our own risk profile. You can find out your own risk profile using risk profiler.
In general, there are 4 categories of risk profile: Conservative, Moderate, Moderately Aggressive, and Aggressive. Each risk profile has its own set of asset allocation as shown below. (Source: Morning Star AIM. Data simulation conducted on a period of 9 years from Sept 1998 to Sept 2006)
Conservative: In this category, preservation of capital and income are the most important objectives, with an average annual total return typically ranging from 4% to 6%. A slightly greater willingness to accept risk is seen in a desire to have a modest positive "real" (after-inflation) rate of return.
Moderate: Investors in this category accept possible principal loss as a natural function of investment risk incurred in the pursuit of higher total return, typically ranging from 7% to 9%. The degree of risk is normally reduced through diversification and asset allocation and periodic revisions to rebalance any excesses that develop.
Moderate Aggressive: Investors in this category are yet more willing to take risk, both in the types of securities held and in the concentration of holdings in favored market sectors. The average annual total return typically ranges from 10% to 14%, but some holdings may be aimed at higher goals. More active portfolio adjustment is a typical feature of this type of investor's behavior.
Aggressive: Investors in this category typically are willing to sustain more in the way of losses on individual transactions in expectation that overall portfolio results in the balance of their holdings will produce average annual total returns of 15% or greater. More concentrated positions and frequent portfolio changes typify this type of investor. Investors in this category may experience a wide variance in results from one year to the next in the pursuit of longer term goals.
To study the impact of the asset allocation, I created 4 model portfolios using unit trust funds available in Malaysia through local fund houses. Each model portfolio contains the same set of unit trust funds. The only differences are the fund sizes in each portfolio. The fund sizes in each portfolio are allocated according to the risk profile of the respective portfolio.
The following is the performance comparison chart for the 4 model portfolios. Notice that all the portfolios follow a similar trend. However, the degree of volatility is different. The most volatile portfolio is the Aggressive Portfolio (4:P). The least volatile portfolio is the Conservative Portfolio (1:P). In between these two risk profiles, are Moderate Portfolio (2:P) and Moderately Aggressive Portfolio (3:P).
Chart 3: Portfolio performance comparison chart.
In a downward market, as shown above, the Aggressive Portfolio (4:P) is the one that drop the most. However, it is also the portfolio that will perform the best in the upward market. Depending on your risk profile, you can choose the portfolio that most suitable for you. If you are the type of investor who are worrying about capital preservation, then you should go for conservative portfolio. However, if that is not your main concern, and you have a long term investment goal, taking a higher risk will probably reward you with more attractive returns in the long run.
Now, ask yourself these important questions:
If your portfolio risk exposure matches your own risk profile, you will have a peace of mind knowing that your hard earned money will not evaporate over night when bad things happen in the market. We can never predict what or when the next market hiccup will happen, but we can reduce the impact of unpredictable events to our portfolio by practicing proper asset allocation. By managing investment risk through asset allocation, achieving your financial goal will become a smoother journey.
Now, let us look at the earlier questions that I mentioned at the begining of this posting, and see if we will be able to answer them now.
Should we start to move out our money to somewhere now? If we practice asset allocation, we will be able to know when we should start switching the funds we own. We will switch the allocation when it does not match our risk profile.
Is there a safe place to park our hard earned money? Our portfolio always has a fixed income asset class. That should be the place we park our money.
For how long should we park our money in a safe instrument and not risk missing out the market up cycle? If we practice asset allocation, at any point in time, we always have a proper percentage of exposure to the equity asset class. By rebalancing our portfolio in a down market, we are indirectly practicing dollar cost averaging for the equity asset class. In a bull market, by rebalancing our portfolio, we are locking in the profits we made in the equity asset class. So, no matter it is a bear market or a bull market, practicing asset allocation will enable us to lock in profit, and stay invest in the market.
Happy investing! :)
Please leave a comment on this blog if you have any questions.
Labels: Asset Allocation, Investment, Unit Trust
