Portfolio Risk Management – Is Asset Allocation Enough?

Every investor knows that asset allocation is one of the basic fundamental tenets of portfolio management. Financial publications, peer-reviewed literature, and books have observed that asset allocation is the significant contributor to the total return. This contribution factor varies anywhere from 50% to 95% depending upon how the data is analyzed with reference to timescale, markets and asset coverage, dividends, inflation, and what not parameters.

What intrigues me is following two issues:

• Look at any successful and well known investors such Buffet, Lynch, Ross, Pickens, etc., and we can observe that none of them followed asset allocation principles. In fact they were highly concentrated in few businesses or companies. E.g. Buffett’s portfolio shows 10 companies represent 85% of the portfolio.
• If asset allocation is supposed to reduce risk, in general, why portfolio managers cannot manage it with low risk and incur drastic negative performance during downturns? Shouldn’t asset allocation provide that downside safety net?
  

As the saying goes, at hindsight everything makes sense. Similarly analyzing the risk data backwards and using those risk models to project forward is a good start. The biggest risk in those models is that they do not consider the macro economic scenario and its relationship to the total returns. As the macro economic environment changes, those assumptions, models, relationship, returns all change. They are no longer valid.

According to me, asset allocation as a standalone factor does not have any meaning. It will not have any impact on managing investor’s portfolio risk. I can be properly allocated in different assets but if my “quality of investments” in each asset class is crappy, it is of no help. I believe that “asset allocation” along with the “quality of investments” is what matters the most.

As an example, the number of companies in dividend aristocrats is reducing. At hindsight, the group of companies in dividend aristocrats has had an excellent run with the growth in US economy. The companies which are still able to keep their aristocrat hat (or new ones that are being added) are the ones which are continuously evolving. They are continuously on the lookout for new opportunities (new products, new markets, emerging markets?). Those are the ones that are of good quality. As a dividend investor, in addition to asset allocation, we also need to continuously monitor the quality of these companies.

Investors should build dividend growth portfolio by investing in four to five good quality companies in each industry segment or asset class. In addition, investors also need to continuously monitor how the quality of company is evolving. Among others, the quality of a company can be monitored by using its ability to generate cash from operating activities and/or its ability to generate free cash flow.

This article was written by Dividend Tree. If you enjoyed this article, please vote for it by clicking the Buzz Up! button below.