Capital allocation in different market conditions

Introduction to capital allocation and market conditions

Capital allocation refers to distributing investment funds across different asset classes, industries, and geographical regions. 

In financial markets, investors and traders continuously analyse, research, and evaluate their strategies to optimise capital allocation under various market conditions. Some traders will focus on short-terms gains, but capital allocation should be a key consideration for anyone seeking to build long-term success and sustainable wealth growth.

Allocation strategies range from shifting towards quality in bull markets to diversifying across asset types and geographical regions in volatile markets. Market conditions may vary based on what is happening in various economies, how asset classes are performing, the evolution of central bank policies, and general investor sentiment.

Market conditions include:

• Bull, bear, and ranging markets
• Muted and volatile markets
• Inflationary and deflationary markets
• Risk-on and risk-off markets
• Monetary policy tightening and easing conditions
• Geopolitically stable or unstable conditions

When an investor or trader is looking to allocate capital, they must understand the current market conditions for various asset classes, and assess the potential factors that could impact them during their trading period.

The 60/40 portfolio allocation strategy

A traditional 60/40 portfolio in investing, often referred to as a balanced portfolio, is a widely recognised asset allocation strategy that consists of a mix of 60% equities (stocks/shares) and 40% fixed-income securities (bonds). This allocation is based on the principles of modern portfolio theory, which aims to achieve a balance between growth potential and risk mitigation.

A popular historical example of the 60/40 portfolio involved allocating 60% of capital to the broad-based SP500 stock market index and 40% to US 10-year treasury bonds.

However, market conditions have changed over time, and this is no longer considered the optimal asset allocation. There are many new asset types that have been developed to create competition for this strategy. Investors, professional traders and fund managers are always looking for ways to outperform such a portfolio by applying various strategies to optimise risk and returns under evolving market conditions.

The Pareto principle for capital allocation

The Pareto principle states that 80% of results come from 20% of inputs for any given event.

Investors may use this approach in capital allocation where 80% of capital is allocated carefully to assets and markets with stable growth and lower risk, while 20% is allocated to riskier investments that have the potential to yield above-market returns.

This approach can be seen in Ark Invest's asset portfolios, which often have anchor assets in an actively managed ETF. For example, the Ark Innovation ETF (ARKK), as of 31st December 2023, invested an estimated 20% in next-generation cloud stocks and distributed the remaining 80% across other selected sectors. The top two stock holdings weighted 18.5% and included aggressive growth stocks: Coinbase and Tesla.

It’s important to note that this capital allocation approach tends to work best in bull markets, and could result poorly in bear markets.

Investing for retirement approach

Individuals or firms investing for retirement often consider a conservative portfolio, since their main focus is on income generation and capital preservation - instead of aggressive growth.

In this approach, managing risk is a top priority. This is typically done by allocating a larger percentage (e.g., 70-80%) to fixed-income securities, such as bonds and cash equivalents, with a smaller allocation to equities. Alternatively, this approach may allocate a larger portion of its stock holdings to high dividend stocks instead of high growth stocks.

Typically, 60-70% of the companies in a conservative portfolio are in what are known as defensive industries. These are the sectors, like utilities, whose products and services typically have demand even during a recession. This indicates that even during challenging times, their share prices will typically hold steady.

Aggressive growth portfolio

An aggressive growth portfolio is an investment strategy that prioritises capital appreciation, over capital preservation and income generation. This type of portfolio is characterised by a high allocation to equities and other high-risk/high-reward assets, with a relatively small allocation to fixed-income securities or cash equivalents.

The primary objective of an aggressive growth portfolio is to achieve maximum profits over the long term. This is often achieved by investing in companies with strong growth prospects, innovative technologies, or disruptive business models.

A good example is the Invesco QQQ Trust Series I (QQQ ETF), which holds over 97% exposure to US stocks, largely in the high-growth tech sector (57%). The top 10 holdings as of January 2024, held 45.98% of the fund.

How to choose the right allocation strategy? 

To keep their portfolio focused on achieving their financial goals, traders and investors might need to adapt their allocation strategy according to current market conditions.

Let’s look at how different market conditions might affect your capital allocation.

Bull, bear, and ranging markets

The fundamental guideline for a bullish market is to progressively shift towards quality. As valuations increase, it’s important to gradually transition to safety and rotate your portfolio to assets that have lower risk and lower volatility.

By balancing gains in one area of your portfolio with losses in another, diversification can help stabilise your holdings during a bear market. You can diversify across various geographical areas since, in a bear market, different markets might behave differently.

In a range-bound market, investors understand that there could be indecision and they might optimise capital allocation by studying potential changes in market dynamics. This is the period when a trend has halted and a potential trend reversal could be imminent. However, it's important to note all markets won’t range at the same time. This means that the investor has an opportunity to reallocate to a different geographical market for high growth or target dividend equities for capital preservation.

Muted and volatile markets

When the market is exceptionally volatile, it's advisable for traders to diversify their positions among stocks, bonds, and short-term investments. Then, diversifying investments within each asset type can further reduce risk. However, it’s also worth remembering that diversifying can neither guarantee profits or protect against losses.

Inflationary and deflationary markets

In a highly inflationary environment, investors target to make returns that outpace the rate of inflation. This implies investing in high-growth stocks or allocating more capital to real estate investments since they tend to do well in highly inflationary market conditions.

Historically, stocks have been a good hedge against inflation over the long term. Look for companies with strong pricing power, robust cash flows, and the ability to pass on increased costs to consumers. Some may also consider allocating a portion of your portfolio to inflation-protected securities like the Treasury Inflation-Protected Securities (TIPS). These bonds provide returns linked to changes in the Consumer Price Index (CPI), increasing the likelihood that an investment will keep pace with inflation.

Deflation is when consumer and asset prices decrease over time and purchasing power increases. This is the mirror image of inflation, which is the gradual increase in prices across the economy. In such an environment, one might consider avoiding risky investments, buying safe-haven assets, and investing in deflation-resistant sectors such as the utilities sector.

Investment-grade bonds, dividend-paying stocks, cash, and defensive stocks (those of consumer goods companies) are examples of deflation hedges. Whatever the state of the economy, a diversified portfolio comprising several kinds of assets might offer some security. 

Risk-on and risk-off markets

When the market is in a "risk off" state, investors typically move their money from riskier investments like stocks, commodities, and high-yield bonds to safer investments like government bonds, gold, and safe-haven currencies like the US dollar (USD) and Japanese yen (JPY).

A risk-on environment is one where there is an increase in the stock market or when equities perform better than bonds.

The market's perception of risk is often reflected in asset values. Investors monitor shifts in sentiment through global central bank action, business earnings, and macroeconomic data.

Some financial institutions offer investment funds that follow a "Risk On, Risk Off" (RORO) strategy. A RORO ETF dynamically adjusts its holdings between higher-risk equities and lower-risk US treasuries, depending on market conditions. An example of such a fund is the ATAC US Rotation ETF.

Markets affected by geopolitical instability

Events related to geopolitics, like conflicts, trade disputes, sanctions, and political instability, can have a big effect on the economy and your portfolio by extension.

Geopolitical instability can change market conditions quickly and result in broken supply chains, stressed external financing, and sudden shifts in central bank monetary policies, among other changes.

It’s difficult to measure or prepare for geopolitical instability and how it affects markets. However, a common trend is to purchase safe-haven assets that typically perform well during times of uncertainty such as gold and cash.

Another effective approach to hedge against geopolitical risk in a portfolio involves diversifying across various asset classes and geographical regions. By spreading investments across different countries and industries, investors can mitigate the impact on their overall portfolio from the performance of a singular asset or market.