Asset Allocation: The Pitfalls Of Extrapolation

There is a running joke in the mutual fund industry that even the ‘Thank You’ slides of marketing decks come with a disclaimer; “past performance is not indicative of future results”. And yet there is no better advertisement for any asset class than recent past performance. It was difficult to drum up any sort of interest for Bitcoin during its languishing years but with recent spectacular returns, interest has now exploded.

The reason perhaps is that our minds are primed to extrapolate. Show a child two dots and she will likely draw a line through them. Rarely will she make a circle, a curve, or a zigzag. But in real life, little else apart from a fixed deposit return is a straight line. Be it economic cycles, fortunes of a cricket team, or returns from an asset class.

Think about how equity markets moved during any year. Never does it look like a straight line from Jan. 1 to Dec. 31. In an especially volatile year like 2020, the BSE Sensex returns were a respectable 16%, but the difference between intra-year low and high points was a huge 84%. To varying degrees, this is true for most years.

Such volatility causes investors to allocate their portfolios on a short-term, tactical basis. All of us have that friend who calls up for equity recommendations when markets are soaring.

In fact, very few people take a strategic approach to investing and their overall asset allocation looks like an unplanned outcome of these short-term decisions. Even if some thought is put behind an overall plan, the allocation is often skewed towards the flavour of the season while yesteryear stars now lie at the bottom of the portfolio like inconsequential memo items.

For the median investor in India, there are four major asset classes to invest in; gold, property, Indian equities, and fixed deposits. At the margin, cryptocurrencies, private investments, international funds, etc. are making their way into asset allocation plans but from a historical standpoint, these four have formed the bulwark of an Indian investor’s portfolio. Their annual returns for the past two decades are in the next table. You will notice that the prize for the annual best-performing asset as also the wooden spoon has frequently changed hands.

To test the asset allocation hypothesis, two portfolios were created. One portfolio, which re-allocates every year on Jan. 1, invests all the money in the best-performing asset class of the preceding year. The other starts with a 25% investment in each asset class and on Jan. 1 every year, re-balances the portfolio to the original 25% weightage.

This exercise starts on Jan. 1, 2000, and since equities were the best-performing asset class in 1999, Portfolio A invests all the money there. On Jan. 1, 2001, it sells the equity portfolio and allocates all its money to fixed deposits since it was the best-performing asset class of the year 2000 and so on.

Portfolio B allocates 25% each to the four asset classes on Jan. 1, 2000. At the end of the year, as fixed deposits and gold have done well relative to equities, the portfolio gets skewed towards these two asset classes. The investor on Jan. 1, 2001, sells some fixed deposits and gold since they have outperformed and buys some equities that have underperformed, to get the overall portfolio allocation back to 25% towards each asset class.

While this difference may not seem large in CAGR terms, the absolute value of Portfolio B is almost 1,000 on an initial investment of 100 while that of Portfolio A is only 714.

Importantly, by being all-in into equities at the beginning of 2008, Portfolio A suffers a huge 55% drawdown while Portfolio B suffers a negligible setback of just 1% as the other three asset classes had healthy positive returns during that year. Another nuance that is missed is the tax implication of the heavy trading that happens in Portfolio A.

The aforementioned 9.3% pre-tax return gets whittled down to 7.1%, even after adjusting for carry-forward tax losses from years of large drawdowns like 2008. Post-tax return for Portfolio B gets lowered by just under 1%, from 11% to 10.1%. Since this is an illustrative exercise, a flat 15% capital gains tax has been assumed here. Higher the effective tax rate, lower the post-tax return for Portfolio A relative to Portfolio B.

Some hard-core equity bugs argue that through the period of two decades, equities have offered the best CAGR of 12%. This is better than even Portfolio B, and by not trading at all you avoided any capital gains. While this is factually correct, the Excel spreadsheet does not highlight the near-impossible mental fortitude that an investor would require to stick through with an only-equities portfolio through bouts of gut-churning volatility and drawdowns. It’s a rare investor who manages to do that.

The basic idea then is simple. Unless you are part of the small group of full-time investors and have other day jobs or passions to pursue, thinking of asset allocation at a portfolio level is important. Even a rudimentary approach like that of equal allocation across asset classes yields very good long-term returns and protects capital. At a time like this, when equities seem to be the only game in town, it’s a worthwhile reminder that extrapolation is a risky assumption.

The idea of a hindsight-based portfolio was originally from an article in The Economist. My former colleague Amay Hattangadi and I did a similar analysis almost nine years ago. I am glad that the conclusions are still intact.

Swanand Kelkar is an investor and former Managing Director at Morgan Stanley. Views are personal.

The views expressed here are those of the author, and do not necessarily represent the views of BloombergQuint or its editorial team.