Rethinking the Balance: Strategies to Enhance Risk and Return

Predetermined asset allocation ratios in balanced portfolios might restrict effective management of risk and return
Risk assessment should be conducted before asset allocation
Diversifying with commodities can effectively mitigate risk

For those seeking to strike a balance between risk and return, but unable to closely monitor the market or lacking clear investment direction, a 'balanced portfolio' is often perceived as the solution, with the assumption that such strategies provide diversification while optimising risk and return. Is this really the case? Let's examine it from a risk perspective.

Typically, a balanced portfolio adheres to a predetermined asset class ratio, such as 50/50 split between stocks and bonds, or a 60/40 combination of equities and bonds. These fixed allocations remain unchanged regardless of market conditions. In times of weak market sentiment, high unemployment, and a fragile economy, a sensible approach would involve reducing exposure to risk assets, such as equities. However, a 60/40 portfolio, constrained by its fixed allocation, is compelled to allocate 60% of the funds to equities, and risk is then only evaluated at the stock-picking level. This rigid approach can lead to a mismatch between risk and return, as a 60% equity allocation may be overly aggressive in a risk-off environment. Conversely, in a bull market with soaring share prices and abundant investment opportunities, the same allocation limit restricts the portfolio from fully capitalising on potential gains, resulting in missed opportunities or forced rebalancing through the sale of stocks, which undermines the strategy's effectiveness.

An enhanced 'balanced portfolio': Prioritise risk before asset allocation

Our team believes that a strategy prioritising asset allocation over risk management may not be the most effective approach to balance risk and return. To achieve an optimal balance, it is essential to first evaluate key market variables collectively, such as economic growth, inflation, fund flows and policy developments, to determine the prevailing market risk level - be it 'risk-on', 'constructive', 'cautious' or 'risk-off'. Volatility should then be factored into the equation before making asset allocation decisions.

While traditional balanced portfolios that allocate solely to equities and bonds may have sufficed in the past, the same approach may no longer effectively achieve diversification while delivering both income and growth. Decades ago, quantitative easing did not exist, nor did we have artificial intelligence to enhance operational efficiencies and drive company valuations. Most importantly, markets traditionally relied on the negative correlation between stocks and bonds - when equities rise, bonds generally remain subdued. However, over the past two years, an atypical trend emerged with both asset classes moving in tandem. A positive correlation between the two erodes their ability to diversify investments and manage risks.

As market dynamics continue to evolve, so too must investment strategies, which should be flexible and provide broader and deeper exposure across multiple asset classes. In addition to global stocks and bonds, commodities - such as energy, gold, and basic metals - have become valuable risk diversifiers. With geopolitical tensions unlikely to subside in the near term, commodities can effectively complement equities and fixed income, enhancing the portfolio in an increasingly complex market environment.

In summary, investors should choose an investment strategy that prioritize risk management in order to achieve an all-weather balance of risk and return.