There has been extensive debate over the last couple of years on whether asset allocation did its job during the financial crisis of 2008-09. Between Mid – 2008 and early 2009 there was a decline in prices of most popular asset classes (Equities, Corporate Bonds, Real Estate). The recent financial crisis we think has not undermined the overall concept of asset allocation but has definitely driven a need to review and update the concept of asset allocation.

In September 2008 the failure of investment bank Lehman Brothers set off a negative domino effect across various asset classes with the exception of US Treasury Bonds and Cash. The bedrock on which Asset Allocation rests – different asset classes perform differently at various times in an economic cycle was undermined. This meant that conventional Asset Allocation also had to include some form of insurance which was guaranteed to perform well in a market crisis.This could have been in the form of deep out of the money put options on the stock market benchmarks which would have protected investors from the severe losses they experienced (similar to protecting another valuable asset – an automobile).

Investors must also focus on moving from a framework of Static Asset Allocation (i.e predetermined allocation percentages across asset classes) to Dynamic Asset Allocation. This would involve setting a wide range for Asset Allocation to particular Asset Classes with some form of valuation/ economic cycle based method to move to the lower or higher end of the range. For example if it were determined that an investor needs to maintain a 60 percent allocation to Equity, on the basis of where the market was trading on a historical valuation basis, Equity Allocation would be higher at 70 percent (if the market were trading at low valuations) or 40 percent (if the market were trading  at high valuations).

The third update on Asset Allocation would be to also evaluate concentration of Assets in particular sub- asset classes and make changes in these exposures to reduce portfolio risk. To follow up on the previous example this would be akin to reducing investments in Banks or Financial Services companies when there is an increased likelihood of an economic recession with a commensurate increase in investments in defensive FMCG companies. In Debt Asset Allocation this is akin to reducing investments in corporate bonds and increasing investments in Government securities on expectations of an economic slowdown.

To conclude while the market crisis of 2008-09 has prompted a review of Asset Allocation, we believe it still works in an updated form.