Intelligent Investor #5 – Why is Asset Allocation Important for Defensive Investors?

In this article, you will have your first approach of asset allocation. I will focus on defensive investors’ asset allocation. This will interest you even if you consider yourself as an enterprising investor. This article is based on our reading of The Intelligent Investor*.

 

What is Asset Allocation?

Asset allocation deals with balancing risk and reward by apportioning your portfolio’s assets according to your goals, risk tolerance and investment horizon (Investopedia).

Asset allocation enables to allocate risk

By dividing your assets between stocks and bonds, you can increase or decrease the risk you take. A bigger portion of stocks in your portfolio means more risk. A bigger portion of bonds means less risk.

Asset allocation also deals with reward expectation

In general, the more stocks you have in your portfolio the higher can be the return on investment.

Risk and reward expectation are linked

If you decide to take a lot of risk, it means that you expect high profits in return. Vanguard—an American investment management company—illustrates this link with examples of returns between 1926 and 2013 for various asset allocation models.

 

Why Do Defensive Investors Need to Focus on Asset Allocation?

Defensive investors need to focus on asset allocation in order to be sure that their investment is safe.

They want to avoid spending much time on their investments. By creating a portfolio that runs on autopilot, they will not spend further effort. So they have to make sure that their assets are well allocated.

Asset Allocation

 

How Should Defensive Investors Allocate their Assets?

In The Intelligent Investor, Graham gave several recommendations regarding apportionment between bonds and stocks.

As defensive investors, we should:
– Have at least 25% in bonds;
– Have a maximum of 75% in bonds.

Why no more than 75% in bonds? Because bonds are more sensitive to inflation than stocks. We must be prepared to a hypothetical increase of inflation.

How to Balance between 25 and 75% in bond?

There are two reasons to limit to 25% in bonds:
1. Although you are a defensive investor, you want high returns. You have to take more risk and to increase the portion of bonds in your portfolio. your money
2. Stocks are extremely cheap and you expect price to grow. This is .
The second point is a a post-crisis scenario. For example, investors who bought stocks in 2009 have made large profits because stock prices were extremely low.

Asset allocation: '20% Bonds/80% Stocks' - More risk, more reward

Asset allocation: ‘20% Bonds/80% Stocks’ = More risk, more reward

 

Conversely, there are two reasons to get close to 75% in bonds:
– Your current situation does not allow you to take risk or you cannot emotionally manage to take risk.
– Stocks are really expensive and you have spotted risk of crisis.

Asset allocation: '80% Bonds/20% Stocks' - Less risk, less reward

Asset allocation: ‘80% Bonds/20% Stocks’ = Less risk, less reward

 

Graham’s Simple Approach of Asset Allocation

Graham recommended defensive investors to follow his 50-50 version of asset allocation. There are several arguments in favor of this approach:
1. It is simple. You do not have to bother with balancing between 25 and 75% in bonds;
2. It limits the risk to 50% of your assets;
3. It lets you some flexibility to buy the right stocks in cases where their prices are increasing.

Periodic Rebalancing

We must focus on asset allocation when we start planning our investing strategy.

Later on, we will need to rebalance our asset allocation on a regular basis (quarter, semester, year). Indeed, our portfolio will change following the market. Maybe we made a mistake by choosing a stock. Perhaps stock prices rapidly grew and our portion of bonds became inferior to 20%.

So once we planned our strategy, we should plan on our calendar when we will rebalance our portfolio.

Take Away

1. Think well about your asset allocation. It is a key part of your strategy as a defensive investor.

2. Take into account your ability and temperament to manage risk.

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*To get more information on asset allocation, I recommend you to read The Intelligent Investor by Ben Graham. Successful investors such as Warren Buffett consider this book as a must-have. Do not miss any opportunity and buy it now.