1: Asset allocation is critical
The most important part of investment is to get the asset allocation right. This is because large proportion of the percent of return variation of a portfolio is explained by the asset allocation.
The above was a research done on the percentage of the actual return variation of balance funds explained by the asset allocation policy. In all countries surveyed, it can be seen that 80% to 90% of the percent of return variation is explained by the asset allocation.
Put it another way around, if you get the asset allocation wrong, your returns are going to be very wrong regardless of what else you do.
From my experience as a professional financial planner, I have found that most people make investment decisions on matters that are unrelated to asset allocation. For example, many retirees buy investment products based on yields rather than asset allocation. That is why a large proportion of retirees like to buy junk bonds.
Below is an actual high networth individual retiree’s asset allocation:
As you can see that the portfolio consists of nearly 85% in high risk investments. This is always because the decision to purchase was based on yield and persuasion by the relationship manager – and not due to asset allocation.
As for the average joe, the typical asset allocation of the average joe’s asset allocation is 99% in properties.
Related to the importance of asset allocation is the ability to use your investments to achieve your goals. For example, if your goal is to retire in 30 years time, the asset allocation will have a higher component in equities. But if your investments are to be liquidated in 5 years time to purchase a house, the asset allocation will tend towards a more conservative portfolio with bonds of duration 5 years and less.
On the other hand, if there are multiple objectives spread across different time horizons – say to purchase a house in 5 years time, children’s education in 10 years time and retirement in 15 years time, then the asset allocation will need to support a multi-stage time horizon. Obviously, the asset allocation is not static but has to be adjusted to meet the objectives of the investors.
The adjustments to the asset allocation need not be done often. Usually I meet and review my clients at least once a year. During the review, we will make a decision to adjust the asset allocation depending on the circumstances.
In this article, I need to give an annual percentage return for each of the point I am trying to make. So let’s say if your financial goals can be met, the investment return has an equivalent additional return of say 3%.
2: Cost matters
Imagine you have two instruments that invests in exactly the same underlying investments. However, product A has an additional 1% per annum of additional cost, which one will you choose?
Assuming an initial investment of $100,000 and a return of 5% before cost, Product A return will be 100000 x (1+5%-1%)30 = $324,339 after 30 years.
On the other hand, the other product will grow to 100000 x ( 1 + 5%)30 = $432,194.
The difference is a whopping $432,194 - 324,339 = $107,855 difference in end results!!
So to avoid investing in high cost products, you just need to avoid these 101 products.
If you want to lower the cost of investment further, that is something very hard to do in Singapore. Most investments in Singapore are expensive. As you cannot have a diversified portfolio of stocks and bonds, you need to invest in unit trusts and ETFs. Unfortunately, most of the ETFs in Singapore has no liquidity. In fact, liquidity woes have affected the entire Singapore stock exchange. You can read the news here: Liquidity woes, IPO drought still dog SGX.
As a financial adviser, I use unit trusts to construct my clients’ portfolio. But for the adventurous investors, they can purchase Exchange Traded Funds in other parts of the world through their own stock brokers. I will still help them select the ETFs to invest in but they need to accept an additional risk – which is the cross border risk as these ETFs are not regulated in Singapore. Although I am still able to monitor their investments using my portfolio monitoring software, most investors are not comfortable investing in ETFs that are traded overseas.
While Accredited Investors can invest in Vanguard funds, there are a lack of low cost choices in Singapore for retail investors. In view of the lack of low cost choices in Singapore, I wrote to the Straits Times on Why exchange-traded funds (ETFs) are not popular here? But the template reply from Monetary Authority of Singapore was a disappointment as it did not provide any practical solution.
Once an asset allocation is decided, the asset allocation would start to drift over time. It is important to regularly rebalance so as to revert the allocation back to the original allocation.
To demonstrate the importance of asset allocation, let’s consider a 70% equity and 30% bonds asset allocation from 1960 to 2013. I am using Australia data but it should apply in any country.
It can be seen above that a portfolio that is regularly rebalanced has a higher return (10.67%) and a lower risk (15.99%) compared to a portfolio that was left to drift.
For the purpose of this article, I assume that rebalancing has the ability to add an additional 35 basis points ( = 10.67 – 10.32 ) to your portfolio.
For me, I rebalance my clients’ portfolio once a year or when they top-up their investments.
4: Behavioral bias
Deputy Prime Minister Tharman Shanmugaratnam recently said that for over 10 years, 80% of CPF Members who invested their CPF did worse than the guaranteed CPF interest. In fact, 45% made losses over the same period. One of the reason he cited was behavioural biases of these investors – which is to buy high and sell low.
Below is a chart to explain what is meant by behavioural bias. Do you see yourselves in this picture?
The following is the evidence Australian investors also buy high and sell low for 10 years period ending 31 December 2013:
In the above table, the funds’ returns are calculated based on time-weighted average return (TWR). This is the return an investor will get if he had invested 10 years ago and did not do anything (top-up or withdrawal) during the entire 10 years period. The TWR is also the published returns of these funds.
The investor’s return is known as the IRR or internal rate of return. This is the true return of the investor. It can be seen that investors’ actual returns were 1.7% to a whopping 7.9% lower than the funds’ returns! This can only be explained by the investors trying to time the market – wrongly!
US investors also buy high and sell low. Read this article for the evidence: Investors always buy high and sell low regardless of asset classes.
How can we avoid committing behavioral bias mistake? It is more difficult than it seems. Many academic studies have shown that behavioral bias mistakes come in different form and sizes. Here is a sample list:
- aversion to ambiguity
- gambler’s fallacy
- loss aversion
- regret minimization
- money illusion
- hindsight bias
- 1/n diversification
- familiarity bias/home bias
- status quo bias
- myopic loss aversion
- endorsement effect
- prudence trap and
- recallability trap
One of the most valuable service a professional financial adviser can do is to act as a mental coach to the investors to avoid these behavioral bias traps. But make sure your financial adviser is not subject to these bias traps him or herself.
For the purpose of this article, let’s give 1.5% additional return of your investments if you can avoid this behavioral biasness.
5: Tax Efficiency
Taxes have to be paid. But no one should be paying beyond what is necessary.
Depending on where you invest, there are withholding tax. For example, ETFs and stocks listed on the New York Exchange are subjected to a withholding tax of 30%. A few months ago, I received an email from an anonymous person who told me he or she has $1 million invested in US. It seems the entire portfolio is in US. I do not know how long this portfolio has been running but if that portfolio has been running for 20 years, majority of the returns would have been given up to the United States government.
Imagine if the average dividend yield is 3%. The withholding tax would increase the expense ratio of a portfolio by a whopping 3%*30% = 0.9%. For a $1m portfolio, that is equivalent to paying a whopping $9000 in taxes every single year! Moreover, there are huge estate duty payable which will wiped up majority of the portfolio on the demise of the investor.
Another area to consider is the usage of tax deferred account such as the SRS. For those who does not know, the capital gains incurred within the SRS is also taxable. Hence, a huge return within the SRS is going to incur large taxes in the future. So should investors use SRS? You can use my SRS calculator to find out.
By the way, never use SRS monies to exercise company issued stock options. A few of my clients did that for many years without realizing how tax inefficient this method is!
For a tax efficient portfolio, I estimate that it will be equivalent of 0.9% of additional value.
6: Total income verses income investing
Many investors prefer to invest in income generating products. This is one of the behavioral bias known as ‘self-control’. Such a bias causes the portfolio to be sub-optimal. There are two reasons for this.
First, high income generating bonds tend to be high yield bonds. The investor tends to overweight credit risk. In other words, you end up taking more risk than another person whose focus is not income generation. Perhaps this is the reason why many retirees ended up with many of these high risk junk bonds because of the need to have an income.
Second, the desire to focus on high dividends stocks results in the portfolio to take on more concentration risk. This is because many high dividends paying stock tends to be REITs and preference shares. Preference shares tend to be issued by banks. Lastly, high dividend paying stocks tend to be value stocks and stocks with no growth potential. So they missed on growth stocks. Hence, their portfolio ends up largely concentrated in REITs, banking sector and a tilt towards value.
In this modern age, it is no longer necessary to differentiate between income producing securities and capital gain focus securities. The portfolio can be constructed based on the asset allocation suitability. Income can be generated using automation (aka FinTech) as described in this article: An example of converting capital gains to an income stream.
Let’s assume the difference in return for an optimal total return approach and a sub-optimal income approach is 1%.
Here is a summary of how to increase your investment returns:
|Strategy||Value add %|
|Potential value added||7.75|
|Suitable asset allocation||3|
|Overcoming behavioral bias||1.5|
|Total-return vs income investing||1|
As it can be seen from the above, it is possible to increase your return by a whopping 7.75%! Of course, some of these are estimates and wild guesses. For example, it is impossible to quantify how the selection of asset allocation add value because every individual’s asset allocation is not likely to be the same as another. Nevertheless, the table above demonstrates that the largest reason why investors’ investments returns are lower than expected is due wrong asset allocation and behavioral bias.
By the way, the additional 7.75% of value add means that if in the ideal world the return is say 6%, it implies you are actually getting 6-7.75 = - 1.75% per annum of return when you are subjected to the 6 problems discussed in this article. This is the reason why the long-term average return of a typical investor is negative. If you reduce your cost of investments by say 1%, you are expected to get a return of -1 .75 + 1 = -0.75% in return.
If you are outsourcing to an investment ‘coach’ to assist you, you can expect a value add of 7.75% less the fee payable to the ‘coach’. For example, if I charge 1%, the maximum value add is 7.75 -1 = 6.75%.
This article was inspired and a number of charts and tables taken from the following sources:
"The global case for strategic and asset allocation and an examination of home bias" by Brian J. Scott, CFA; James Balsamo; Kelly N. McShane; Christos Tasopoulos. September 2016
"Putting a value on your value: Quantifying Vanguard Adviser's Alpha (Australia edition)" by Francis M. Kinniry Jr., Colleen M. Jaconetti, CPA, CFP®, Paul W. Chin, F Fin, Frank Polanco, PhD, CFA,and Yan Zilbering. February 2015
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