The key to long-term wealth generation is the creation of an efficient portfolio through the appropriate allocation of assets. Each portfolio must be individually constructed according to the needs and preferences of individual investors. However, while investors frequently know what they want, they may be unaware of what they require in terms of asset selection and fund allocation proportions to achieve their portfolio objectives.
In terms of average return, return volatility or risk, and taxation, each asset class exhibits distinct characteristics. In addition, the impact of macroeconomic factors, such as growth, inflation, and government finances, which collectively comprise the business cycle, on different asset classes is distinct. For instance, equity returns were typically higher during the upswings of business cycles. Similarly, gold often performed better during periods of high inflation. As the phase of the business cycle is likely to have a significant impact on portfolio performance, it is only natural to modify the asset allocation of a portfolio based on the phase of the business cycle.
The tactical approach to portfolio construction suggests that the proportion of pro-cyclical assets, such as equities and real estate, should be increased at the beginning of a business cycle and decreased as the cycle matures. The opposite is true for counter-cyclical assets, such as bonds and gold, which provide a higher return during a business cycle downturn.
Under this strategy, portfolio allocation should be based on investor preferences such as return expectations, risk tolerance, anticipated fund addition and withdrawal needs. Once the long-term allocations have been determined, the strategic approach discourages frequent portfolio changes. It suggests rebalancing a portfolio if a strategy consistently produces suboptimal results over a substantial time. Due to the fluctuating prices of individual assets, actual portfolio allocation can diverge significantly from the desired strategic allocation. The strategic approach encourages reallocation in such circumstances.
The strategic approach does not preclude sporadic portfolio underperformance but emphasises longer-term results. However, there is no established rule regarding how long such poor performance should be tolerated. There is also little assurance that improved portfolio performance in the future will compensate for past underperformance. Similarly, even if the portfolio eventually achieves the desired performance, the intermittent underperformance can cause significant investor anxiety and, as a result, irrational investor decision-making.
In terms of practical outcomes, tactical and strategic portfolio allocation is not very dissimilar. Most seasoned professional portfolio advisors favour long-term allocation strategies. A significant number of them also favour limited portfolio reallocation based on the phase of the business cycle. If pro-cyclical assets deliver superior returns during the expansion, the proportion of these assets would exceed strategic allocation as the cycle develops.
In conclusion, strategic portfolio allocation should be the preferred route with rebalancing on a periodical basis.
(The writer is founder and chairman, Anand Rathi Group)