Asset Allocation in China: Crafting the Optimal Allocation Strategy, Episode I

Author: Randy Cohen, Senior Lecturer of Entrepreneurial Management at Harvard Business School, Member of Advisory Board at Bridge Point Capital


Historically, people around the world have invested the vast majority of their assets in their home country, and the people of China are no exception. Such behavior is driven by a combination of factors, including regulations, transaction costs, taxes, and a greater comfort with the local market. In recent years, as barriers to global investing have become less common and the benefits of diversification have become more widely known, investors in many countries have taken the opportunity to reduce risk by broadening the array of assets in their portfolios.

This report presents evidence that many Chinese investors have an extraordinary opportunity to benefit from international diversification. The report proceeds in four parts. The first section contains an analysis of the classic ‘unconstrained’ asset allocation problem. We present evidence that investors, who face no regulatory barriers, transaction costs, taxes, or other restrictions, typically can obtain extremely large benefits by diversifying the household portfolio. The second section presents information on the asset allocation approach taken by Harvard Management Company when they took on the portfolio allocation problem. The third section explains the special status of Chinese investors and the special opportunities and limitations that these investors may encounter. China’s special status puts Chinese investors in a situation that differs in some important ways from that of U.S. or European investors. Finally, the fourth section lays out central principles to be considered in asset allocation. This includes a summary of the inputs and outputs of an asset allocation model, as well as many factors outside the standard model that should be accounted for by investors wishing to get the best possible risk-return tradeoff customized to their needs.


1.1 Overview

Decisions about how much to save and how to invest play a key role in driving household wealth. Household behavior in the United States, China, and elsewhere, often appears sub-optimal, in the sense that many households would with high probability be better off if they made certain low-cost changes in their investing and asset allocation policies. The study of the science of household investing began with the pioneering work of researchers such as Markowitz (1952), Sharpe (1964), and Lintner (1965), among others. The key fact about human nature that underlies their work is that households, choosing portfolios in an environment characterized by uncertain returns, prefer portfolios that deliver higher expected returns, while at the same time having lower levels of risk. This tradeoff between risk and return is the essence of portfolio choice. A key insight that comes out from this pioneering early theoretical work is that diversification is essential.

The research on household investing in the United States has highlighted a number of interesting puzzles. We use this term, ‘puzzles,’ to describe areas where observed household behavior appears to be sub-optimal -- that is, where we observe people choosing portfolios that offer lower expected returns and higher risk than could be obtained with a different investment strategy. This suboptimality is, in general, relative to the guidance that came from the work on portfolio choice mentioned above – work that highlighted, in particular, the importance of diversification. Some of these puzzles can be explained by the presence of certain constraints. For example, regulations or taxes may prevent households from investing in the way that they would otherwise prefer. Other behaviors remain puzzling even after reasonable account is taken of the constraints that households face; in such cases it may be that investors are making choices that hurt their performance because they are being affected by psychological biases. We will use the observed puzzles as a framework to build up from the simple, and relatively inefficient, portfolios many investors hold to the diversified portfolios held by the most sophisticated market participants.

1.2 Diversifying across asset classes

Broadly speaking, investments can be placed into three categories:

  • Fixed Income assets such as cash and bonds;

  • Public Equities, i.e. the stock market;

  • and Alternative Investments, including hedge funds, real estate, private equity, and other categories.

Essentially all investors hold some fixed-income securities, if only in the form of a bank account. So our first puzzle -- the most common way in which investors fail to build smart portfolios -- is the failure of many investors to participate in equity markets at all. It is common practice, in the U.S. as well as globally, for less-sophisticated investors to hold fixed income and nothing else. As highlighted by a number of researchers over the years, most households have zero or minimal investments in the stock market. Among the papers that demonstrated this are Mankiw and Zeldes (1991), and Bertaut and Starr-McCluer (2000).

This non-participation in equity markets is a ‘puzzle’ to be explained for two reasons. First, as we will discuss in detail below, more diversification is generally better. And second, historically stocks have performed so well. While stocks are riskier than bonds, their historical payoff has offered more than ample compensation. For example, the arithmetic average annual return on the US stock market during the period between 1926 and 2015 is 12.0 percent. This compares to an average return on US Treasury Bills of 3.5 percent, and an average return on 10-year US Treasury Bonds of 6.0 percent. It is important to note that this period includes the market downturn around the 1929 stock market crash and subsequent Depression, the 1987 stock market crash, and the period of the Great Recession that started in 2007. Even including the downturns, equity markets have massively outperformed fixed-income assets, beating Treasury Bills by a full 8 percent per year.

This annual outperformance, cumulated over long periods of time, becomes extremely important due to the power of compounding. Exhibit 2 shows the growth of $1 invested in stocks, compared to Treasury Bills, Treasury Bonds, and the growth of inflation over the same period. A dollar invested in the stock market in 1926 was worth $5,466 in 2015, compared to $21 for a dollar invested in Treasury Bills. Inflation over the same period has meant that it takes $13 in 2015 to have the same purchasing power as $1 in 1926. So in inflation-adjusted terms, the cash investor gained less than 50% over a long lifetime, while the stock investor's money grew more than 420-fold!

Historically many investors failed to take advantage of the opportunity offered by the stock market because participation required paying a heavy price in money and effort, a cost that only the wealthy saw as justified. But now with the existence of low-cost financial advice and market access through mutual funds, ETFs, and other vehicles, even investors with modest wealth should absolutely consider equities and fixed income as both being important parts of a diversified portfolio.