Why asset allocation is king

In 1992, one of the most important hip hop emcees of all time (and arguably, the most influential), Rakim, released his “don’t sweat the technique” song which puzzled some fans.

They wondered why the most technically-gifted artist would downplay his own superior lyricism. His answer: The audience is the only (important) thing.

In other words, his message was more important than style.

To tie this together, exactly 30 years prior, an economist by the name Harry Markowitz introduced the modern portfolio theory (MPT) which had a similar take: it’s not your trading style, its asset allocation that counts.

In today’s article, I pen some thoughts on why asset allocation is king.

To start with, a very important person once said, “If clouds are full of water, they empty themselves on the earth. Whether a tree falls to the South or to the North, in the place where it falls, there it will lie”.

His explanation was simple. Between two investments, no one knows which will succeed, or whether both will do equally well.

Therefore, the only cure is to stay diversified in order to catch the winner. Waiting for hot tips is a fool’s errand. It’s akin to chasing after the wind.

For instance, taking a moderate-aggressive approach, say 60 percent stocks and 40 percent bonds. The point is, for the average investor, not thinking about your portfolio picks every time the wind shifts, is actually liberating. And that’s one beauty with asset allocation.

Secondly, an asset allocation approach allows one to focus on what’s important — portfolio yield. I have long been baffled on why the power of dividends and interest income is massively undersold.

This is in spite of numerous studies showing investment income historically playing a significant role in total return.

In particular, when average annual equity returns have been negative, dividend income has been known to account as much 40-50 percent of the total return.

In our case, Nairobi Exchange Securities’ (NSE) “lost season” between 2013-2018 period where equity returns (price-only) were negative, dividends kept the boat floating.

In all, focusing on equities with high payout ratios (especially those with growing annual dividend per share) and prioritising tax-free infrastructure bonds can immensely boost your overall yield.

Further, adding rental yield into the mix should give the portfolio a nice cushion. Overall, yield in the range of 4-5 percent annually is not bad at all.

Finally, asset allocation helps one stay away from the mutual fund myth. By now, you know funds have largely failed to work. So why pay someone a lot of money to pick stocks or bonds? Active management is less important as the winners and losers in the fund often average out much like the broader market. And this is even before factoring in agent and management fees, brokerage commissions and other expense ratio items.

To summarise, please remember: markets are hard to beat and only broad exposure is best. Gladly for ordinary investors, no one has to sweat the technique.