To protect ourselves from the present market volatility, investors can consider using the simple “80:20 rule” on asset allocation — invest up to 80% when the market is bullish and reduce to 20% if the market is in for a big correction.
Q: GIVEN the uncertainties over the future direction of the stock market, what should I do now?
A: Despite all the goodies from Budget 2008, our market was unable to escape from the effects of sharp drop in the US market.
The weaker-than-expected US job data raised concerns over a possible economic recession soon. At present, given that our market is highly influenced by the performance of the overseas markets, some retailers have started to feel uneasy, mulling over whether to sell all their shares and hold only cash, or continue holding on to their stocks given our positive economic outlook for next year.
It is always difficult to time the stock market. It requires the ability to depart from a normal investment stance when the market offers an unusual opportunity. Hence, to stay on top, investors need to be able to act in contrary to a misguided consensus with a thorough analysis on the risks and rewards.
According to a groundbreaking study in 1986 by Gary P. Brinson, L. Randolph Hood and Gilbert L. Beebower titled Determinants of Portfolio Performance, asset allocation affects more than 90% of portfolio performance. Hence, in view of the uncertainties over the future direction of the stock market, we need to make the appropriate asset allocations to hedge against any risks as a result of big volatility in the stock market.
Assuming investors have only two types of asset classes in one portfolio, i.e. cash and stocks, we would suggest that the asset allocation ratio between cash and stocks should always be 20:80.
If there are any uncertainties over the future market direction, investors should reduce their equity exposure on a staggered basis to 20%. The remaining 80% of the assets will be in cash.
However, if the market has dropped to a very low level and the overall market sentiment starts to turn bullish, we will increase our equity exposure to a limit of 80% and maintain 20% in cash.
The main reason for setting an upper limit for stock investments at 80% is the fact that stock price movements are always unpredictable and random. Unless there is a very attractive opportunity, we should always try to maintain a minimum 20% cash in the portfolio.
If more than 80% of our portfolio is invested in equity, any increase in stock prices would be a good opportunity to sell down to our target level of 80% in stocks and 20% cash.
If the stock market touches a new high and starts to show signs of a correction, investors need to consider adjusting down their equity exposure to about 20%.
However, the 20% invested level is with the assumption that the economy remains intact and the outlook positive. We should only start to increase the invested percentage when the market has found a bottom and shows a clearer outlook.
Besides, investors may need to set a target floor level, which is the maximum loss that they can tolerate.
According to Andre F. Perold and William F. Sharpe in their study titled Dynamic Strategies for Asset Allocation, one of the suggested methods is called Constant-Proportion Portfolio Insurance (CPPI).
This method entails setting a floor limit for the inventor’s portfolio based on his tolerance level. If the overall portfolio drops below this floor level, the portfolio will hold only cash and has no exposure in equity. This method is found to be quite useful in a super bear market when the economy slips into recession.
The above simple “80:20” rule is just a basic guide on asset allocation and is not foolproof. The ultimate asset allocation is still dependent on the stock market outlook and investors’ risk tolerance. (This rule is not the same as the Pareto Principle (also known as the 80:20 rule), as the latter states that 80% of the consequences stem from 20% of the causes).
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