An important investment strategy is asset allocation and in this article, I share my Asset Allocation Dinner Party Analogy to explain the concept of asset allocation and how anyone can do it intuitively.
What is Asset Allocation?
Here is the academic definition of asset allocation. Asset allocation is an investment strategy that aims to balance risk and reward by creating an investment portfolio that is made up of different asset classes.
An asset class is a group of securities (financial assets) that have similar financial characteristics, behave similarly in the marketplace, and are subject to the same laws and regulations. The three main asset classes are equities (stocks), fixed-income (bonds) and cash equivalents (money market instruments). ~ Wikipedia
The reason why asset allocation works is based on the principle that different assets perform differently in different market and economic conditions.
There is no exact formula that can be used to determine what the exact asset allocation should be for every investor. However, the general guide to determine the exact asset allocation in a portfolio is based on the individual’s investment goals, risk tolerance and time horizon.
The consensus among most financial professionals is that asset allocation of the portfolio is more important than the actual selection of the individual financial assets or securities that make up the portfolio.
If you are a new investor, this might sound very technical or academic and may seem hard to understand.
However, let me show you that asset allocation is actually something you can understand easily and can do intuitively even though you have no investing experience or education. In fact, even a housewife with no formal education would be able to understand asset allocation easily and be naturally good at it.
I call this the:
Asset Allocation Dinner Party Analogy
First, let me lay out the following scenario. Your spouse or partner has asked you to help plan a menu for a dinner party for 10 of his/ her friends.
The assumptions are:
1) Your partner is very busy at work and can’t be contacted for the day so no information about the guests was given to you. You have no idea who they are and what they like to eat.
2) You want to do your best to make this dinner party a huge success and make everyone happy
3) You know how to cook and will be buying the food/ ingredients and preparing the food yourself
4) You have a fixed budget that you cannot exceed. Say, $100.
Bearing the above assumptions, how would you go about planning the menu for this dinner party?
Specifically, how many dishes and what exact dishes would you plan to prepare? (We will exclude drinks and beverages from this discussion).
Think about this for a minute and write them down.
In a while, I will tell you how most people who I shared this analogy with responded.
Let’s see how you did.
I’m quite sure you would have come up with a similar dinner party menu.
Based on the budget, most people felt they could offer 4 – 5 dishes. Let’s work with 5 dishes for the sake of this discussion. For the sake of this discussion, we will not take about drinks and stick to just the food menu.
The most common 5 dishes proposed included:
1) A chicken dish such as fried chicken wings or roast chicken
2) Another meat dish such as steamed fish, grilled fish or pork chops.
3) A salad or cooked vegetables dish
4) A fried rice or noodles
5) A dessert such as a fruit platter, cake, ice cream, mango pudding or Tang Yuan (Glutinous Rice Balls in a sweet soup)
Did you come up with something similar?
I’m quite sure you did, unless you are a Ninja Turtle or a teenager, in which case, you probably thought of just making three different types of pizza (true story).
I suspect it was also quite easy for you to plan this dinner party menu.
In essence, you have intuitively practiced asset allocation. The dinner party menu is just like your investment portfolio. Let me explain.
First, let’s match the dinner party assumptions to one’s investment assumptions.
1) You have no information on the guests. This is similar to not knowing what the market conditions will be in future or how your investments will perform. Although in reality, you will not be so “blind” going into an investment. More on this later.
2) You want to do your best to make the dinner party a huge success. This equates to you wanting your investment portfolio to make as much money as possible.
3) You will be buying the food/ ingredients and preparing the food yourself. Instead of relying on a financial planner or personal finance manager, you will be creating your own portfolio and executing all trades yourself.
4) You have a fixed budget that you cannot exceed. This is the same as your investment capital which is likely to be limited or a specified amount.
When you planned the dinner party menu, you chose different dishes that are completely different from each other to create a balanced menu.
The hope is that all guests will like all the different dishes but it they don’t, there will be at least some that they would like. This is diversification, which is the same concept behind asset allocation in investing.
You are ensuring your portfolio is made up of different assets to spread out your risk. You invest in different asset classes just in case when some do not perform well, there will others that perform well and keep your overall portfolio healthy.
Some dishes such as chicken wings or a roast chicken/ duck are chosen because they are considered dependable favourites for most people. They might also be considered the main course or the most filling and most expensive dish in the menu.
This is similar to choosing large-cap or blue chip stocks that are well-established companies that are financially very stable. In Singapore’s context, these are companies like DBS, UOB, Singtel and SPH.
Blue Chip Stocks
The vegetable dish is an important component of the menu but usually not the “star” of the menu. Not all guests may like vegetables but almost everyone agrees it should be part of the diet and menu. Even meat lovers will grudgingly agree that a little fibre is necessary in a meal.
The same can be said of “safe” dishes such as fried rice or noodles. The likelihood is that no one (or not many) is going to dislike these “safe” dishes but no one is necessarily going to rave about it but most people (if not everyone) are happy that this dish is available.
I equate these type of dishes to a low risk but lower reward asset such as bonds or cash/ cash equivalents. The general consensus amongst all financial professionals is that even the most aggressive passive investment portfolios should have a component of low risk assets.
Cash & Cash Equivalents
Some dishes may be more exotic or “special” like a signature fish head curry or spicy tofu minced pork stew. Maybe, these exotic dishes have been big hits with many guests before, although some people may not have liked them because they do not like spicy food. But the rave reviews from the guests who did enjoy these exotic dishes still make it worth doing.
This is similar to small-mid cap stocks that are high risk but also high reward. Not all small-mid cap stocks may do well but if you choose one that does, you might do exceptionally well. Just imagine if you invested with Apple, Google or Facebook at the start.
Small-Mid Cap “Growth” Stocks
The dessert could be a hit or miss, depending what sort of dessert it is and how health conscious the guests are. But generally, most guests will be content to take a bit even if they do not finish the entire portion.
This is similar to alternative investments that might make up a fraction of your portion like precious metals or commodities. Not every investor feels a need for alternatives in their portfolio but those who do use it is as a diversification tool or hedge for inflation.
Alternatives, Precious Metals or Commodities
As you probably realize now, for the dinner party menu, you intuitively chose dishes with completely different base ingredients from each other. You did this because you know different people have different tastes and different people like/ dislike different things.
This is the same fundamental concept of asset allocation in investing. You choose different asset classes based on the principle that different assets perform differently in different market and economic conditions.
In addition, you most likely prepare the different dishes in different ways with different marinades or sauces. It is unlikely you would cook everything exactly the same way with soy sauce and garlic. This is another example of how you intuitively diversified your menu. It is not enough that you chose dishes with different base ingredients but you would also cook the dishes differently so they do not all taste the same.
In investing, you need to ensure that the assets that make up your portfolio are not perfectly correlated to each other.
For example, an amateur investor might invest in an airline stock, a bond issued by an oil producer and crude oil commodity, thinking they are different types of securities in different industries and different asset classes. However, all these financial assets are correlated because they are dependent on oil supply and prices. Any movement in oil supply or price will affect all the investments.
Just as you would not cook different food in exactly the same way, you will not invest in different assets that are very closely correlated with each other.
One of the assumptions I made at the beginning of this analogy was that you had no idea who the guests are and what they like to eat. In reality, this is a very unlikely scenario. If you are hosting a dinner party, you will have some information that allows you to make informed decisions when it comes to preparing your menu.
For example, how will the following information affect your dinner party menu?
Half the guests are vegetarians
Two of the guests are Muslims
Some of the guests cannot take spicy food
Knowing the above information will likely change your menu significantly. For example, you might prepare two vegetable dishes instead of one or you might go all vegetarian.
Out of respect for the Muslim guests, you might ensure you do not use any pork in your dishes.
Finally, you might not prepare any spicy dishes or might have chilli on the side for guests who do like spice.
In investing, while no one can predict 100% how a stock or the market will perform, you should be doing research to make similar informed decisions when creating your portfolio. You will use fundamental and/ or technical analysis to analyze a security before investing in it.
You will research the sector thoroughly to see what the short or long term future/ potential holds for that particular sector.
You will also talk to industry experts, seasoned investors or read research reports to see what experts think of the potential of a stock/ sector.
All this information coupled with your investment goals, risk tolerance and time horizon will allow you to determine what asset allocation you should have in your portfolio; specifically, what asset classes to invest in and in what proportion.
I hope my “Asset Allocation Dinner Party Analogy” has helped explain asset allocation in investing and more importantly, shown that at the conceptual level, it is intuitive for most people.
Keep this analogy at the back of your mind when you construct your passive investment portfolio and ensure it is properly diversified.
Remember, asset allocation of the portfolio is more important than the actual selection of the individual financial assets or securities that make up the portfolio.