Investing Without a Plan
Ask a CIO #27
This was the year that our family was going to get our holiday card out early. We scheduled family photos with an amazing photographer. We received the proofs and picked out our favorites. With small kids, pretty much any photo with everyone looking at the camera and smiling is a minor miracle – and we had multiple to choose from!
All of this before Thanksgiving. And yet, our card remains unfinished. We all know the saying about best laid plans. Tomorrow is definitely the day we finish the card and place the order. Probably.
This week’s question poses the possibility of forgoing planning altogether when building an investment portfolio.
Do you need an asset allocation policy? Can you instead focus on selecting high quality managers bottom-up that have orthogonal investments and collectively meet the portfolios' liquidity needs?
I’m admittedly curious when I encounter resistance to the idea of asset allocation policies. After all, asset allocation policies are based on investors’ own personal inputs. These policies translate any given return target and resulting risk expectation (or in reverse, any given risk tolerance and resulting return expectation) into an actionable framework.
These policies are not meant to be rigidly constraining. And although they should be considered strategic and fairly long-term in nature, investors are free to change their asset allocations as their risk/return inputs change. Even an asset allocation of 100% equities qualifies as a perfectly valid policy, if that’s the risk an investor actively and consciously chooses to take.
Applied thoughtfully, asset allocation frameworks generally promote investment discipline, reminding investors to rebalance periodically to stay within their own risk tolerances. In periods of macro uncertainty, which can be surprisingly often, these strategic policies serve as guideposts toward sound decision making.
But, if an investor truly doesn’t want an asset allocation framework, then let me at least share a few potential considerations.
A portfolio of orthogonal investments might not share the same risk-drivers of returns, but each investment still carries its own risks. I’ll use litigation finance as an example.1 It is, generally speaking, a strategy that produces returns uncorrelated to equities or credit investments. Depending on the particulars of the litigation finance strategy, an investor might instead assume significant legal process risk. The investment might very well be compelling, but without a coherent risk and return framework, how does an investor anchor the price of taking that risk? In other words, how does an investor determine if the expected return justifies the risk?
In my experience, a purely bottom-up strategy can also introduce shared risks to the portfolio that are not immediately apparent. Let’s take a perhaps obvious example – three different funds managing three different strategies: convertible arbitrage, market neutral long/short equities, and managed futures. These strategies look different on the surface (and they are different), and they’re expected to produce non-correlated returns to each other in normal environments. They’re also levered strategies potentially exposed to the same risk of forced selling in a deleveraging cycle.2
And as I’ve noted before, there are no points for complexity in investing. Part of the appeal of an asset allocation policy is that it often reveals the least complex path to reaching an investor’s risk and return goals. It seems counterproductive to underwrite a strategy incorporating nine-legged trades to generate equity-like returns (I’m totally exaggerating here in this hypothetical investment, but you get the idea).
So yes, I think you do need an asset allocation policy. Portfolio construction matters. Understanding the risks taken in the portfolio and the rationale behind taking those risks matters.3
To wrap up, I’ll just say that I’ve occasionally seen the end results of these exclusively bottom-up investment approaches. Portfolios accumulated over time, with incremental investments added that are “interesting” and “uncorrelated.” From what I’ve seen, these portfolios very rarely seem to end up in a coherent place. Is it truly a collection of high-quality orthogonal investments? Or just a random assortment of odds and ends put together in no strategic order? Perhaps it depends on the eye of the beholder.
Thanks for joining, and as always, don’t hesitate to reach out: askacio@ivyinvest.co!
Until next week,
Wendy
In full disclosure, Ivy Invest has exposure to litigation finance as part of an asset-based lending investment. This is not a recommendation and should not be considered an offer to buy or sell these securities.
A portfolio might own unintended risks across multiple investments irrespective of any asset allocation policy. The point here is more around the value of viewing a portfolio holistically and not just as a grouping of individual investments.
Without getting into a discussion on benchmarking, which could take up a whole newsletter and put everyone to sleep at the same time, another way to think about it is that a policy portfolio provides a control against which to measure the variable of any prospective investment.