Why higher equity allocation is optimal for long-term investors

Why higher equity allocation is optimal for long-term investors?


Many investors have carried their exposure to stocks through 2008 in the hope that these stocks would generate positive returns if they hold on longer.

If their hopes have indeed come true, there is a lesson for long-term investors: construct portfolios with higher equity allocation.

But are stocks less risky over the long term?

This article explains time diversification — the notion that the risk of stocks declines as time horizon increases.

It discusses why experts are still divided on the subject. It then suggests why it is optimal for investors to carry higher equity allocation without engaging in time diversification.

Long-term investment is typically an after-thought. Or to be precise, it is usually a short-term investment that has turned wrong!

But does extending the time horizon help? Jeremy Siegel in his book “Stocks for the long run” states that stocks produced positive real returns in excess of both bonds and Treasury bills over longer time horizons.

Intuitively then, extending time horizon makes sense. Suppose a portfolio was set-up in October 2003 with the objective of doubling capital in five years. The portfolio would have fallen short by seven percentage points in October 2008. Extending the investment horizon by a year would have served the objective.

Suppose the portfolio was instead set-up with a strict five-year time horizon. Some experts argue that the terminal wealth then becomes important. That is, an investor should not be bothered about yearly volatility in asset prices as much as the holding-period volatility.

But that may not be true. Suppose the average yearly volatility over five years is 20 per cent while the five-year holding-period volatility is only 7.5 per cent. An investor has to first endure five one-year periods to realise the five-year holding period.

And that could be painful for many. This is one of the reasons critics argue that extending time horizon does not reduce risk.

So, the question remains:
Should investors with longer time horizon have higher equity allocations?

Behavioural investing
Suppose an investor wanting to buy a house in five years time constructs a portfolio today with a higher equity allocation.

The investor will regret the decision if equity prices decline at the horizon. Importantly, the investor has to then settle for a smaller house if the portfolio does not generate enough to buy the desired real estate. Extending time horizon in this case moderates the regret.

If equity prices, however, climb up sharply within five years, the investor experiences pride of making gainful allocation, not to mention the joy of buying a larger real estate.

A discerning investor, therefore, wants to balance pride and regret. Making higher equity allocation, hence, assumes importance.

But can investors take higher equity exposure without engaging in time diversification?
The answer lies in constructing the portfolio within a core-satellite framework. It is clear that a strict buy-and-hold strategy will not be optimal in a volatile world.

The investor, therefore, needs to construct a passive core at various price points using the concept of rupee cost averaging. This portfolio will be held for five years, subject to periodic risk rebalancing.

The pain of regret associated with this portfolio could be high, if equity returns trail bond returns.

This pain could be offset with the satellite portfolio, which will be actively traded to take advantage of the high intermediate volatility.

Note that the actual asset allocation policy would be drawn up based on the time horizon and the risk appetite of the investor, a factor dependent on a person’s human capital.

Conclusion


Extending time horizon may not always make stocks less risky. It is true that a portfolio can generate higher returns in 10 years compared with five years.

But risk may also increase with horizon due to high intermediate volatility. Nevertheless, higher equity allocation may be optimal for long-term investors based on pride-regret behaviour