Every financial literature and tutorial has drilled into our brains that asset allocation is one of the basic fundamental tenets of portfolio management. Financial publications, peer-reviewed literature, and books have observed that asset allocation is the significant contributor to the total return. This contribution factor varies anywhere from 50% to 95% depending upon how the data is analyzed with reference to timescale, markets and asset coverage, dividends, inflation, and what not parameters.

What intrigues me is following two issues:

  1. Look at any historically successful and well known investors in US, e.g. Buffet, Lynch, Ross, Pickens, etc., and one will find that none of them followed asset allocation principles. In fact they were highly concentrated in few businesses or companies. E.g. Buffett’s portfolio shows 10 companies represent 85% of the portfolio.
  2. If asset allocation is supposed to reduce risk, in general, why portfolio or fund managers cannot manage it with low risk and incur drastic negative performance during downturns? Shouldn’t asset allocation provide that downside safety net? Isn’t that what means by risk management. If a fund goes down with the market, then what is the point of risk management?

As the saying goes, at hindsight everything makes sense. Similarly, analyzing the risk data backwards and using those risk models to project forward is a good start (Note: only good start). The biggest risk in those models is that they do not consider the macro economic scenario and its relationship to the total returns. As the macro economic environment changes, those assumptions, models, relationship, returns all change. They are no longer valid. Let us take an example; it is widely purported that stocks always go up on long term basis. The way I look at this is – it is true only if the economy is on growth trajectory. It is true only for companies that adapt, companies that have good management, professionally managed, and sustainable business models. Stock is not going to up if the company has crappy business model, crappy management, etc.

According to me, asset allocation as a standalone factor does not have any meaning. It will not have any impact on managing investor’s portfolio risk. I can be properly allocated in different assets but if my quality of investments in each asset class is crappy, it is of no help. I believe that asset allocation along with the quality of investments is what matters the most.

  • Take Reliance Group as an example. When the company realized that it cannot grow more in petrochemicals, it diversified into petroleum, infrastructure, telecon, etc. The management makes effort to focus on ensuring long-term sustainability.
  • Take another example of Larsen and Toubro. Historically, it was making machinery for cement industry. Over the period of time, it has diversified into civil engineering, industrial engineering, large turnkey EPC projects, power, hydro carbons, etc. The professionally managed company makes effort for long-term sustainability.
  • On the other side, take an example of Hindustan Motors (remember – Ambassador Brand). Indian economy has grown leaps and bounds in last two decades. But what happened to Hindustan Motors. It did not adapt and hence, driving itself to road of extinction.
  • Similarly, if the present hot shot Infotechs and BPOs companies do not adapt, they will in the same situation. Time will tell how they evolve, if not, than the writing is on the wall. They need to reduce its dependence on US market and labor arbitrage alone.

I think you are getting my point. So now that we know quality of company is important. The question is how do we measure the quality of the company?

I believe the dividends paid by the company are a very good measure for continuously accessing quality of company over a period of time. Typically, dividends are paid from company’s earnings. If the company is consistently growing its earning, I expect to have consistently growing dividends. This thought process is the cornerstone of my income portfolio strategy. I am focusing on companies that pay dividends and have consistently growing trends in earnings.

I believe, I should build my income portfolio by investing in at least five to seven companies in each industry segment and/or asset class. If the companies demonstrate slow consistent growth year after year, then my income portfolio will not only have an increasing dividend cash flow but also have relatively higher potential for capital appreciation.

In future posts, I will continue the discussion on different aspects of asset allocations and how it affects the construction, sustainability, and management of my income portfolio.