Opinion – Grain in Grain: What allocation strategies can be applied to your portfolio?

The strategy that most investors would like to employ in retirement and probably before retirement is only effective in a certain scenario. This scenario is one where assets only go up. However, we know that this scenario does not always occur, as risky assets are volatile by nature. But is having a strategy relevant?

The importance of having an allocation strategy lies in the fact that the allocation decision between equities and fixed income is, in general, more relevant to the portfolio outcome than the specific choice of which stocks should be in the portfolio.

He had promised to talk about what is the best strategy to use in his retirement. However, to understand why a strategy is more suitable, it is important to understand which strategies are available and their characteristics.

Today I will briefly explain the three main strategies. In order not to get tiring, in the next articles I will go into detail about each one. For example, in which market scenario does each strategy perform best and how to apply it to your portfolio?

In the chart below I present the result of the implementation in the last 22 years of the three main allocation strategies: Buy and Hold (BH), Constant Mix (CM) e Constant Proportion Portfolio Insurance (CPPI).

The graph shows the evolution of R$ 100 thousand invested in each of the three strategies since the end of 1999. Only two assets were used: the Ibovespa and the CDI.

All three portfolios start with the same proportion of 75% on the Ibovespa and 25% on the CDI. But the proportion changes over time, according to the way each strategy is balanced.

The BH strategy is one of the best known and simplest. In this approach, the investor defines an initial division between equities and fixed income, buys the assets and keeps them without rebalancing throughout the investment period.

Given its passive feature, that is, it does not require any movement, it attracts the attention of many investors.

Another very commented and used strategy is the CM. In it, the investor determines a proportion of the portfolio in stocks and his job is to rebalance the portfolio periodically to keep this proportion constant. Thus, when stocks fall, the investor should rebalance the portfolio by buying and, when stocks rise, he must sell the stocks, always returning to the initial proportion in the portfolio.

It seems intuitive to most investors to buy when stocks fall and sell when they rise. Hence the interest and its wide use.

Finally, a more elaborate strategy that is more difficult to implement is the CPPI. In it, the investor must act counter-intuitively. You should sell when the stock goes down and you should increase exposure when the stock goes up. However, the great secret of this strategy is to ensure that the risk allocation, that is, the share in shares, is only carried out when there is a safety cushion.

At CPPI, the safety cushion is calculated by the difference between the value of the portfolio and a minimum value for the portfolio that is determined by the investor. This minimum amount can be corrected by the fixed income. Thus, the CPPI will do at least as well as the fixed income return on the minimum portfolio value.

And now, which strategy have you been using in your portfolio?

Which strategy should deliver the best result? Which of these three strategies do you think would be the most appropriate to employ in your retirement?

I will answer these questions in the next articles.

Michael Viriato is an investment advisor and founding partner of Investor’s House

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