Let me open today’s post with a question. How do we decide what is an effective asset allocation for us?
As individual investors we all know that we need to maintain a diversified asset allocation in our portfolios. We are also aware of different types of asset class and investment vehicles. Unfortunately, for most of us individual investors (note: individual investors) that’s where we hit dead end on asset allocation discussions. We really do not know how to engineer a portfolio that has optimum asset allocation for our risk profile.
Theoretically, asset allocation is a risk management methodology driven by relationship between expected return and risk. Can we use this classical approach of asset allocation to dividend investing? It can be argued that the inclusion of dividends in ‘expected return’ captures the dividends, and hence, it can be applied. My viewpoint is, these asset allocation methodologies are driven by expected return on capital. We dividend investors know that in short (3 to 5 years) to intermediate (5 to 8 years) term the dividends have a small contribution to the total return. The significant contribution of dividends starts to accelerate after 10 to 12 years. In addition, the dividend investors would find that asset allocation becomes very challenging, particular with reference to foreign (developed and emerging) asset classes.
In this context, I looked at David Swensen’s work with Yale Endowment Fund (source). This is an institutional fund, therefore, may not have a direct bearing on individual investors. I am including it in this discussion to highlight how the fund’s asset allocation is managed by using ‘expected real return’ and ‘standard deviation of the returns’. The table below shows the different asset classes with expected real return and standard deviations.
In this table, we can see that every asset class has its own expected return and its corresponding standard deviation. In general, I was quite surprised by the single digit expected real return and higher percentage of standard deviations (in 20s). The expected real return excludes inflation, but still it appears to be quite different than the generally purported value of approximately 10% (domestic equity) and 10+% (foreign equity).
The interesting point in this asset allocation methodology is the use of concept of expected return. Keeping with this methodology, as a dividend investor, I have recently started doing following: