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Beyond Diversification: All About Asset Allocation

In a new book, Sébastien Page explains how professional money managers construct investment portfolios

If you’re a serious student of the subject -- investing, that is -- this is the book for you.

Beyond Diversification: What Every Investor Needs to Know About Asset Allocation by Sébastien Page, head of global multi-asset at T. Rowe Price, falls somewhere between the required readings to become a chartered financial analyst or a certified investment management analyst and books that contain phrases such as Idiot’s Guide or Dummies.

The goal, Page said in an interview, was to show investors (and financial advisers for that matter) how professional money managers construct investment portfolios.

“It’s not a technical book,” he said in an interview and video.

But it’s not brain candy either. “There's substance in there,” he said.


Risk and Return Forecasting

The first two parts of the book are about the ingredients that go into constructing an investment portfolio: return forecasting and risk forecasting. The third part is the part where you learn how to construct a portfolio, and that’s the part we focused on in our interview.

But first this: Every investor is told at some point in their life, perhaps multiple times over the course of their life, this: Don’t put all your eggs in one basket.

Instead, you should spread your money among various investments in the hope that if one investment loses money, the other investments will more than make up for those losses. It’s called diversification.

So, what could possibly be beyond that? Isn’t that the be-all-and-end-all when it comes to asset allocation and portfolio construction?

Yes and no, says Page. “If you give me 30 seconds to give an investor investment advice,” he said, “I'm going to say, ‘stay invested for the long run and diversify.’ So, I'm not arguing against the principle of diversification. I would argue it’s one of the most important pieces of advice you could give someone if you only have 30 seconds to talk about investments.”

But the book is titled “beyond diversification” because diversification, in the way it's interpreted by many people is a flawed concept and allocating your assets goes way beyond diversification.”

Why can diversification be a flawed concept?

First, many investors really don’t diversify their investments properly. In fact, many 401(k) plan participants invest their money using the 1/n approach; they put equal amounts of money in however many investment choices they have in their 401(k). Ten investment funds translate into one-tenth in each fund.

“We say diversify, stay invested for the long run,” he said. “This is simple advice. But there's a lot of thinking and there's a lot of subtlety around how you do that.”

What’s more, he said diversification doesn't necessarily work the same in different market environments. “This is something that people know, that the pros know, but that as an industry, we underestimate the impact of that,” said Page, who in the book presents model portfolios that highlight downside risk exposure.

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7 Rules of Thumb for Portfolio Construction

Page also discussed what he described as his top seven rules of thumb for portfolio construction, rules we should note that assume that the hard work of on return and risk forecasting has been done.

1. Don’t use risk factors as substitutes for asset classes – no need to overhaul portfolio construction.

“This is a new concept in our industry as substitutes for asset classes,” he said. “I don't think there's a need to overhaul portfolio construction to move away from asset classes toward risk factors.”

Yes, risk factor analysis for the pros, at least those that have the tools to do it can be quite useful for risk forecasting, but, he said, there's no need to rethink portfolios and away from asset classes toward risk factors.

2. Use risk factor models to assess portfolio diversification, forecast risk, and enhance scenarios.

Here's one way to think about it. Let’s say you're invested in stocks and high yield bonds. With your high yield bonds you have, in part, some equity-like exposure, he said. “This portion of the high yield bond looks and acts like a stock, especially in down markets, is all part of the same risk factor. So, rethink diversification that way.”

3. Consider risk premiums as possible small stand-alone investments but beware of backtest results.

Page said those looking at factor investing to generate returns ought to do so carefully. “Those can be interesting as part of portfolio construction but… you really need to be careful with backtest results” and “probably command a relatively small allocation.”

4. Solve this question first: What stock-bond mix matches the investor’s goals and risk tolerance?

This, said Page, is the most important question you need to solve for, and it really influences your long-term results. It’s largely a function of how far you are from retirement. “But,” he said, “how much you should allocate to stocks and bonds also depends on what capital markets can offer going forward. What is the long run expected return on stocks and bonds? That will, should influence your allocation.”

Ultimately, you want a nest egg that's big enough at retirement to replace your salary once you retire.

But if you’re not on track to achieving that goal you might have to change your stock-bond allocation.

Don’t despair by the way if you’re having trouble devising your stock-bond allocation. Nobel Prize Winner Bill Sharpe once described the use of savings in retirement, this lifecycle investing decision, as “the nastiest, hardest problem in finance.”

And the crux of it is: “How much stocks should I hold relative to bonds,” said Page.

That single decision, he said, is also quite important in (T. Rowe Price’s) target-date fund strategies.

And if ever you’re in doubt about your stock-bond allocation, look at target-date fund strategies as they provide “a good anchor point,” Page said.

5. Use portfolio optimization models, judgment, and experience to populate the stock-bond mix.

Once you’ve established your broad stock-bond mix you then have to get more granular. How should you allocate your stocks? What percent should go in international, value, growth, large-cap, mid-cap, small-cap, and so on? The same exercise goes for bonds.

6. Consider alternatives as diversifiers but beware of inflated returns and underreported risks.

Investors, even individual investors need to consider alternatives, whether liquid or less liquid alternatives that are now available more broadly, said Page. “I don't think they are a free lunch, but in a world where interest rates are very low and bonds won't give you the same diversification going forward alternatives have a place in investor's portfolio,” he said noting that some of the model portfolios in his book substitute about 12% of the bond allocation for low volatility alternatives.

7. Allocate between active and passive strategies as a function of active risk tolerance and fees.

“My view is that most investors should allocate between active and passive strategy as a function of risk tolerance in a low return world,” he said. “Active management done well can deliver excess return over time. And that can become an important part of portfolio construction for investors. A lot of investors nowadays end up with some mix of active and passive, which to me makes sense.

Is 60/40 Dead?

Is 60/40 dead? It’s certainly a popular question. And many professionals have delivered eulogies. But Page isn’t in that camp. He doesn’t think it’s dead. But it does “need some tweaks” given current market conditions, given what we can expect going forward from capital markets, and given advances in portfolio construction and asset allocation.

You can certainly start with 60/40. It’s very generic advice. “But that's not really the spirit of the question,” he said. “The spirit of the question is what should we do beyond traditional stocks and bonds, right? Burgers and beers, right?”

For instance, in the model portfolios Page provides in the book he substitutes 12% from bonds to alternative types of assets.

And he swaps about 5% to 10% of the equity allocation for risk-mitigated equity products. Those strategies, he said, typically seek to deliver 70% to 80% of the return of equities with as little as half of the exposure to loss or the volatility. What’s more, the concept of risk-mitigated equities used in the institutional money manager space and is now making its way to the individual investor space, he said, because rates are so low.

As for sample portfolios, Page provides something for everyone. There’s a table that details what your asset allocation could be throughout the life-cycle – from 20 years away from retirement to 20 years into retirement. Plus, there are sample portfolios for every type of investment objective: conservative income, diversified income, diversified global, growth, and defensive equity.

When to Rebalance and Why

Of course, no discussion about investment management would be complete without at least broaching the subject of rebalancing. According to Page, there are four rebalancing methods. But his preferred method, at least for most investors, is to put tolerance bands around your allocations and rebalance when the allocations rise above or fall below those tolerance bands.

The other point about rebalancing worth noting is that studies show “that generally it pays over time to be contrarian and rebalancing helps investors do that with some discipline,” he said. “If you lean into the markets when you become underweight in your stock allocation, over time, it pays off. You don't need to time the bottom perfectly.”

But, Page said, “it’s good discipline to bring your equity allocation back to its target when everyone else is panicking.”

Likewise, when your equity allocation rises above the tolerance band “you can bring them back” to the target allocation.

Bottom line: It's probably better to use tolerance bands than just simple calendar-based rules when rebalancing. And, it pays over time to be contrarians on rebalancing. “All else being equal is good investment discipline,” he said.

Ultimately, Page describes his book as being about professional asset allocation and the innovations in that space. “It's a book that challenges you to learn. There's a lot in there, but I think it's a rewarding read for those willing to put in the time to learn more about asset allocation.”

One last note. Page’s proceeds from the book will go to the T. Rowe Foundation, which is committed to supporting long-term community impact through youth empowerment, creativity, and innovation, and comprehensive approaches to hunger, poverty, and homelessness in Baltimore and around the world.