Right allocation - key to high returns and right risk

Investing is not about finding the top and the bottom of the markets. One of the most effective risk management tools and a key ingredient to successful investment is the correct allocation. What does this term mean, and why is it so important? What is the role of bonds in the portfolio and is it worth investing even with a short investment horizon?

Radoslav Kasík | Investment academy | 29. October 2019

We are constantly trying to predict the development of markets. We try to estimate the decline and the rise of asset prices and to correctly time the appropriate buy and sale of investments. Most of us postpone investing as a result of our own expectations and beliefs. Forecasting future is part of the financial markets from their beginning and investors will always try to do it.

Professionals also take part in market forecasting. In addition, they will base their expectations on analyzes and facts that convince themselves that their claims are correct. This makes their forecasts more credible to the public.

Paradoxically, they always try to predict the fall in stock prices. Negative news attracts more attention, thus making it easier for them to gain media space. But the question of how they increase the value of theirs and their client’s assets is always left out.

The main issue with this effort is that it opens the door to investing based on emotions. Sooner or later, impressions and distorted facts will enter into market predictions and will push out rational arguments. Decision-making is then influenced by emotions such as fear of loss, greed, self-confidence, mental short-sightedness, and others.

There are many factors, influences, and news at the same time, often contradictory to each other, making it difficult to make rational decisions. Moreover, the behavior of human society does not follow the exact pattern and people do not always respond to events in a textbook way.

Emotions are natural and especially very human. We will never be able to push them out of our lives, nor will we ever completely control them. Ultimately, without emotions, our lives would be considerably poorer. As they say, to each his own. As a result, we have diversity and varieties in societies, and without different expectations, even the markets themselves could not work effectively.

The reason why we try to predict and time the markets (timing when to buy and sell) is the thought of limiting potential losses, thus minimizing the risk of investments. Unfortunately, this approach has little to do with risk management.

It usually results in not taking a risk, i.e., not investing. Intelligent investors already know that there is no return without risk. Consequently, timing the markets leads to assets not earning and depreciating. There is a simple equation in which the risk always increases with the return.

Any successful forecasting of market developments is more of a result of a chance and luck rather than true skill or knowledge. Very few realize that it is exactly this effort, trying to anticipate markets, that in most cases increases the risk of investment.

On the contrary, as many mistakenly believe, the likelihood of higher returns is actually reduced by human intervention. We are prone to errors, especially when investing. Any decision carries the risk of incorrect selection. The more decisions we have to make when investing, the greater the chance of failure.

 Source: Ivanhoff Capital, Apríl 2010

Numerous studies and especially the results of the vast majority of professional and amateurs’ investors confirm one fundamental fact - financial markets and asset price developments cannot be predicted with accuracy by anyone.

Although we are constantly trying to accomplish this, it is tilting at windmills that will only deprive you of money in the long term. Just look at your own investment history, how have you appreciated your assets in recent years.

Nevertheless, we can eliminate the risk. Experience has shown that the most effective risk management tools are mainly sufficient time (long investment horizon), diversification, the regularity of investment and correct allocation. These tools ensure that erroneous emotions are kept out.

The right allocation or assignment of an investment is defined as its distribution among the basic asset classes. The purpose of choosing a suitable investment mix is to select a portfolio with expected return and also with an acceptable risk, based on the investor’s risks profile.

In the world of finance, the correct allocation is defined as an investment strategy that aims to balance the portfolio's risk and return by appropriately composing it according to the individual investment goals, risk profile and investment horizon.

The basic classes of investment assets are only equities, bonds and cash. The allocation is represented using these three classes of financial assets. The purpose of the allocation is to optimize risk taken and potential return.

In general, equities are the riskiest asset from the basic classes of investment, i.e. they have historically achieved the highest returns, but their prices have the highest fluctuation (volatility). Bonds generate lower returns and their prices are much more stable. Cash does not generate any return and neither does it have any volatility.

Investing does not mean only buying equities. Bonds also have their roles in investors' portfolios, they reduce the volatility of investment (fluctuation in value). Bond prices often develop oppositely to equities prices and their fluctuations are smaller.

The following table shows the role of the bonds in the portfolio. It shows the average annual return, the annual volatility (the spread of annual appreciation), the number of drops that exceed 10% and the maximum drop in Finax's sample portfolios with a different share of equities and bonds, i.e. with different risks, over the past 31.5 years.

The table also shows the Sharpe ratio. This ratio was developed by economist William Sharpe, Nobel Prize laureate. Sharpe was devoted to asset valuation. In the long run, he was not satisfied with the evaluation of investments based only on the achieved returns, because this approach does not take into account the risk that had to be taken.

The simple ratio of return to the corresponding volatility representing risk is an indicator that shows the return achieved per unit of risk taken. Sharpe's ratio is also called the risk-weighted return. The higher the ratio is, the more interesting the investment is in terms of return and risk, or in other words, you get a higher return in relation to the risk taken.

Interestingly, based on risk-weighted return, is over the past 31.5 years the portfolio consisting of 20% equities and 80% bonds considered the best portfolio of Intelligent Investing. But in terms of long-term returns, we offer eight more portfolios that are more attractive.

This is the foundation-stone of investing. The return you expect should primarily depend on the time you are willing to give the investment and the risk you are willing to take.

This relationship is illustrated by another table, which is well known to the majority of intelligent investors. It shows the probability of profitability of four selected portfolios with different allocations and thus risks on different horizons.

With time we can completely eliminate the risks of dynamic strategies. If you cannot give this time to money and still want higher returns than a bank will provide, you need to invest more conservatively (more bond weighted).

The more bonds the investment contains, the less risky it is. A higher proportion of bonds in the portfolio is suitable in the following situations:

  • I have a short investment horizon - If you are willing to commit money only for a shorter period of time, e.g. 5 years or less, or you don't know exactly when you might need the funds, bonds must play a bigger role in your portfolio. A shorter horizon cannot be the reason for avoiding investment and holding cash, which will only guarantee you a loss. However, the minimum investment horizon should be at least 2 years.
  • I am worried about the fall of markets – Drops are an integral part of the markets and they will certainly occur in the future, but nobody knows exactly when it will happen. Again, this is not a valid argument for not investing, as the only alternative is to let the savings depreciate by holding them in cash or at the bank. Just have a look at the past decade, which has brought massive profits to the financial markets, but because of fear, most people have not participated in this growth with their financial assets. Solutions that help with reducing the impact of the falls of markets are just to provide enough time for investments, or a more conservative portfolio allocation - a larger share of bonds.
  • I am risk-averse, I can't handle big fluctuations in investment value - First of all, it's a tough-luck for your financial assets, because unless you change your mindset you won't use the full potential of your savings. However, you can invest carefully with more focus on bonds. With an investment, you must feel comfortable otherwise it won’t be suitable for you. Over time, you may become more accustomed to investing, increasing your risk tolerance
  • I am afraid to invest; I do not understand investing - This is one of the biggest mistakes you can make in your life. If you are able to save a certain amount of money on a monthly basis, you have made the most important and the most difficult step towards financial independence and a better quality of life. Trust us and believe in time-proven facts and successful investors. All wealthy people invest and increase their assets by investing. Investing is no longer just their privilege. Investing works and there is no reason to hesitate or postpone it. Time is money. When investing, this statement is even more essential. The more time you give to the investment, the bigger the return will be. Therefore, start as soon as possible. Feel free to start slowly and gradually. Familiarize yourself with investing using a more conservative investment (with a greater weight of bonds).
  • I have no experience with investing – There is a first time for anything. If you don't try something, you won't learn it. We were not born with the knowledge of how to swim, bike, drive or work with a computer. Yet these activities are an integral part of our every day lives. Make investing equally part of your daily life. The right investment allocation can help you. Start conservatively, build up experience, get to know and understand your investment, and your earnings will grow over time.
  • I invest a large number of my assets on a one-time basis or the invested funds are crucial for my future and life - If you invest too much in relation to your financial situation investing too dynamically is not recommended. In situations where the sources of your income do not significantly exceed your expenses or when the investment is a large part of your total assets, bonds should definitely be part of your portfolio. These are cases where you are not sure if the money invested may be needed in the near future to maintain your standard of living, or you do not have any other liquid assets, or the goal of the investment is to create a source of income (regular rent)

 

If your life situation does not correspond to any of the above-mentioned cases, you invest regularly and only part of your savings and you are able to give the invested funds enough time (at least 10 years), do not be afraid to let the equities be a bigger part of your portfolio. The best way to eliminate stock risk is with a long-term horizon.

The following two graphs accurately illustrate the difference in volatility and growth of the different investment allocation. Portfolios with a larger share of bond funds fluctuate less, their value does not fall as significantly in the event of market downturns, but they do not earn as much in the long run as investments where equities have a bigger share.

The first graph shows the development of two sample portfolios of Finax, a growth portfolio consisting of 80% equities and 20% bonds and a conservative portfolio consisting of 20% equities and 80% bonds in the last 20 years. The second graph illustrates the development of our clients' accounts with a one-off investment from the end of September 2018 to the end of June 2019, one with a 100% equities strategy and the other with a 50:50

Market forecasting and their timing is not a key to successful risk management or higher returns. Do not try to do the impossible because you deprive your property of appreciation.

Only sufficient time and correct allocation of a well-diversified portfolio will protect you from the risk.

Instead, learn to define your goals precisely and determine how much of your assets and regular savings can you allocate and for how long. Feel free to set multiple goals with different horizons and divide your savings between them. This will keep your money available at all times during your life.

Keep only the necessary liquid reserve in the bank. Treat the medium-term objectives planned in the three- to seven-year horizons with conservative or balanced portfolios. Address long-term goals such as retirement savings, asset building or savings for children with dynamic portfolios.

How to choose the right allocation for specific investment goals?

We have just offered you a basic guide on how to choose the right investment. For the beginner, it might seem all Greek but it should in no way discourage anyone from investing.

Finax also thought of this issue. As the first robo-advisor (online advisor) in Central Europe, we have completely simplified the investment process through the use of technology and your financial agent or registration on our site will guide you through it.

You just have to evaluate your financial situation, set your financial goals, and we'll do the rest for you. In Finax, you can have up to 99 accounts per portfolio management contract. On each account, you can pursue a different goal with a different horizon, or even with a different portfolio and risk

If you answer the questions truthfully and in accordance with your life plans, you can be sure that we will choose a portfolio that accurately corresponds to the risks to your goals, characteristics, and capabilities.

Consequently, it is only up to you whether you will stick to your intentions, which is the basic condition and the only requirement for a successful investment and peaceful sleep.

Of course, life situations can change for everyone. We have also thought of these cases. We offer high investment flexibility. You can regularly review and change your goals or extend them. Everything can be resolved comfortable online or with your agent who knows your situation and you have trust in them.

Investing correctly and profitably has never been easier in Slovakia.

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