Condivergence: What is the best asset allocation strategy?

This article first appeared in Forum, The Edge Malaysia Weekly, on June 7, 2021 - June 13, 2021.
Condivergence: What is the best asset allocation strategy?
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The secret of making money is very simple: buy low, sell high. Winners have a good asset allocation strategy, plus luck. Losers do the opposite — they sell low, buy high.

During the pandemic, retail investors have come back to the stock market in droves. The reason is very simple — they are getting lower and lower returns on their bonds and bank deposits. Even though they lost money before in the stock market, taking bets there is not only fun, but if they strike it rich, they feel good, tell their friends, and before you know it, every Tom, Dick and Harry is piling in. People love to boast about their winnings, but they rarely talk about their losses.

Asset allocation strategy is far more important than you can imagine. This is the first thing your financial planner or adviser will talk about. Where do you put your money, and how effective is your strategy?

When I was running the foreign exchange reserves portfolio in Hong Kong, the expert in charge always repeated the fundamental principles of returns, risk and liquidity. What is the return on assets (ROA)? What is the risk of capital loss? How much liquidity should you have?

Actually, it is never just ROA but ROE (return on equity), because you can always increase your returns through leveraging, namely, buying assets funded by debt. Your equity (assets net of liabilities) remains the same, but the leverage — assets or liabilities growing larger than equity — increases. The downside is your returns increase at the cost of incurring volatility risk, since sharp drops in asset price would also exponentially increase your losses.

Liquidity is very important, because if you don’t have cash, you might not be able to buy an opportunity. Worse, you may be forced to sell assets even at a loss to meet your contractual obligations. Crowded exits, that is when everyone is trying to exit the market, creates panic selling and huge losses to everyone.

Liquidity crises are the main reason central banks exist: to provide emergency liquidity when needed. Most financial crises occur because liquidity crises end up as solvency crises. Selling assets at huge losses while the real value of debt increases makes many borrowers bankrupt, and eventually, the banking system also fails when non-performing loans outweigh the bank’s equity. If all depositors pull out of the bank, the bank goes bankrupt in a chain reaction.

There are three Knows in this business: know yourself; know your business; and know your risks. Knowing yourself (because you are your own customer) is very important, because your investment strategy must fit your individual and special needs. A young person can afford to invest for the long term and therefore, take more risks.

A person on the point of retiring just wants a steady income and can’t afford to lose his or her capital. But I know young people who are extremely conservative and remain poor, whereas some silver-haired investors bought Bitcoin or high-tech stocks and ended up very rich. Luck and skills decide who ends up in tears, because there are few consistent winners.

KYB, or know your business, means you must know what business you are in and what you are buying or selling. Investment is a business that must be learnt with discipline. It means buying with your eyes wide open. Gambling is buying with your eyes shut. If you don’t know what you are buying, then you are gambling. Therefore, it pays to study the business and products before you invest. And if you don’t know, allocating a small amount to learn is not a bad strategy.

Knowing your risks is related to the first two. Every product has different risks, and even if you think you understand the risks, when the price drops suddenly, you find that your risk appetite is much less than you think. So cutting losses by selling the shares may end up saving you from worse losses, but may also mean opportunity lost, because the shares may rebound suddenly. Only you yourself can find out whether you have such nerves of steel to buy when everyone is panicking, or sell when everyone is buying. You pay to learn that.

The standard investment allocation is between real assets, such as your house, antiques or gold, versus financial assets, typically bank deposits, bonds or stocks. Physical assets protect you against inflation, but often have no liquidity. Your house is not an investment to be traded — it’s a necessity. But most wage earners have something like half the bulk of their assets in housing, half in financial assets. The half in financial assets could be roughly divided into 5%-10% in cash, 20% in provident (EPF), insurance or retirement funds, and the remainder in mutual funds or stocks.

The first principle we all learn is diversification or “never put all your eggs in one basket”. The second is investment style — value investing or momentum investing. The former is applied by the famous investor Warren Buffett, and the latter is used by chartists, who draw technical charts on when to buy or sell by following market trends.

Buffett’s style has made him lots of money, because his secret is actually to invest in good businesses that have good franchises (locked-in profits protected by franchise grip on market, such as Walmart, Apple and Coca-Cola). Chartists care less about value but buy when the market is moving and sell before it heads south. Technical chartists essentially follow the crowd and enjoy the market momentum, with the aim of getting out before the market turns. But calling the top or the bottom is very difficult.

In essence, the market is driven by greed and fear. Don’t be too greedy. I know many long-term investors who started out as speculators. They held onto their winning streak, refused to sell and ended up with losses when the stock tanked. Of course, each successful investor has his or her own unique style. Some, like the famous Bernie Madoff, make up the profits through false accounting.

In essence, do your homework. What is too good to be true often is.

The principle of strategic asset allocation is much more universal in application, because every day or minute, we are allocating our precious time (another asset) to decide what to do for the short term (the urgent or mundane) or the long term (important but difficult).

We never value our time properly, many postponing difficult decisions because they don’t know how to make the decision, or because they think they have time later on to make that decision. Then Covid-19 comes, and you lose your job or become ill and then regret that you do not have enough cash, are not prepared for contingencies, or have not kept yourself healthy through daily exercise and discipline.

Another area of blindness in asset allocation is to remember that you are your own best asset. A career choice between a salary or wage earner, or a business venture, is an asset allocation decision. Do you commit yourself to a long-term, low-income stream, or devote your talent to a high-risk, high-return business? In most small businesses, the main asset is not physical assets, but the owner’s own talent, reputation and brand.

The reason why your parents want you to be a professional is they are hedging the bet. If you are trained as a professional, you get a steady income. If you fail as an entrepreneur, you can still go back to being a professional. Notice how some successful politicians are doctors? If they fail as a politician, they can go back to a steady income and customers as a doctor. Risk hedged.

The really dangerous politician is one whose future income depends on being a politician, so they bet your money and future with their political asset allocation strategy. And since politics needs money, are you surprised that money politics corrupts absolutely?

Money politics is a businessman buying insurance that the politician might even benefit his business. On the other side, money politics is the politician’s asset allocation strategy of using money to beat his competition. Winner takes all and the loser is the public.

Of course, some career choices are not made by the individual but by circumstances, sometimes beyond their control. JK Rowling was a divorcee with a young child in relative poverty when she decided to write the Harry Potter series that made her billions. Your talent may be worth more than what your employer thinks you are worth. Your worth depends on how confident you are in your ideas and will to succeed. Life is not a 100-metre dash, but a marathon. Those with will and stamina succeed.

But prosperity is also related to the bigger picture. We all agree that China has outperformed in terms of GDP growth and wealth creation, and yet investing in the Chinese stock market has not been good. However, the recent growth in the Chinese stock market is in tech stocks, just as the outperforming US stocks are the tech stocks.

One WeChat comment I saw asked why the best talent in China went to America to help in the tech boom, but they did not make as much money as their less-talented colleagues who remained in China. On the other hand, the best tech companies in the US (such as Google, Microsoft and IBM) are run by Indians. Indian top tech talent went either for these American big companies or remained in the Indian software houses like Infosys, Wipro or HCL Technologies, which are software service companies to the US/European markets. The Chinese tech talent in the US went into business themselves, creating the Zooms of this world, but most stayed as tech specialists for a salary.

On the other hand, those who remained in China created the Alibabas, Tencents or Xiaomis that made them billionaires. Chinese education focused on STEM (science, technology, engineering and mathematics) skills, stressing IQ (intelligence quotient), whereas Indian education was English-based, with excellent social or EQ (emotional quotient) skills. Thus, Indian management skills are much appreciated in top Western multinationals, but Chinese technical skills without articulation (in English) meant that very few of them could reach the top in the West.

On the other hand, Chinese EQ is well adjusted to Chinese society, so those with high tech and high Chinese EQ succeed in a Chinese environment. No wonder Taiwanese and even Chinese Malaysian tech talent have done very well in China.

The key lesson from this story is that education choice in IQ versus EQ is also an asset allocation decision. The Asian mentality and culture is that if our generation does not do well, we invest heavily in education for our children to prepare them for the next generation. The best universities in the world have far higher Asian intakes than their own local populations, so much so that there is now reverse discrimination against Asians.

Thus, the key investment allocation strategy is to KYB, know how the bigger context is changing, and where you want your future to be in. If you think that global risks are greater and more uncertain, then you hedge your bets. It is not surprising that many Asian families are now scattered around the world, becoming more multicultural. They are actually diversifying their geographical risks to where the best returns are.

Asians are much more open to risk, because they understand that without risk, there are no opportunities. But IQ alone is not enough. EQ, or the ability to emotionally get everyone to work together, is critical. Group action enables the collective to defend itself against the predator. Look at how starlings or bats fly together as one large dance to defend themselves against attacking hawks. A single stray is immediately picked off and killed.

Asians are lucky that they grow up in a high-growth zone, so their wealth has done much better than someone growing up in the Middle East, Latin America or Africa. But even if on average the group performs well, it does not mean that an individual will perform well. Thus, to join the outperform group, one must use brains rather than brawn. Education is still the key to a better life.

Asset allocation is therefore not just about managing money, but managing one’s own life and destiny. Choose wisely. Your future depends on it.


Andrew Sheng is a former central banker whose views are personal to himself

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