How a good valuation model can help you decide your asset allocation

A well-documented and practical quantitative valuation model can assess investment opportunities more objectively than relying solely on subjective judgments. These models can be beneficial in making investment decisions across multiple asset classes like domestic equity, fixed income, gold, foreign equity etc. Using checklists can effectively reduce the effects of cognitive biases when investing in the market, ensure essential factors are not overlooked, promote consistency and help stay disciplined.

Several widely used valuation ratios such as Price-to-Earnings Ratio (P/E Ratio), Price-to-Book Ratio (P/B Ratio), Bond Equity Earning Yield Ratio (BER), Market Cap to GDP Ratio are parameters. , Gold to Dollar Ratio, Developed Market to Emerging Market Valuation Premium/Discount etc.

A detailed primer of some of the essential prerequisites of a good quantitative valuation model is outlined below:

Model parameters need to be mean-reverting

In finance, mean-reversion refers to the idea that, over the long term, asset price ratios tend toward their long-term averages or means. Mean-reverting ratios can be helpful in asset allocation decisions because they can help identify potentially under-valued asset classes.

For example, the commonly used P/E ratio, P/B ratio, BER, etc. are mean-reverting investment ratios. This means that if these ratios are above their historical averages, they are more likely to decrease in the future and vice versa.

Model parameters should complement each other and provide a comprehensive picture

Each of the complementary criteria provides unique information about the attractiveness of the asset class, and by combining them, the model can provide a more accurate and complete picture of asset class valuations.

For example, when using equity market over- or under-valuation (via P/B ratio), it is important to analyze fixed income market valuation and thus, the relative attractiveness (via BER ratio) between these two asset classes. say through).

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The model should be reviewed periodically to include only “structural changes”.

Structural change refers to long-term changes in the underlying structure of an economy. For example, in 2019, the government reduced corporate tax rates after several years, which will ultimately improve the after-tax profitability of companies (keeping all other things constant). Therefore, it becomes important to review the model parameters used and the rebalancing range to incorporate any new “structural changes”.

Must be accommodated for non-recurring or/and special events

These are usually one-time or occasional events that require adjustment. For example, the lockdown has adversely affected the profits of many companies for a period of time. Therefore it becomes important to adjust for these non-recurring events using financial ratios to give a more accurate picture.

Model results should also be tested on non-sample (out-of-sample) data

Out-of-sample data refers to a set of data that is different from the data that was used to develop the quantitative model. This data is commonly used to test the accuracy and generalizability of the model.

In other words, out-of-sample data is a way of evaluating how well a model can predict outcomes on new, unseen data based on its performance on back-tested data.

regime change should include

Regime change refers to a significant change in the system of governance, a new constitution, a new legal framework, or the political structure of a country. Working with raw data as input to a model that includes two completely different regimes (for example, the pre- and post-liberalisation periods) can make the model’s results irrelevant or biased.

The overlay used should be logical as well as help improve the results

An overlay factor is an additional variable or set of variables added to improve the accuracy of a model. No assessment tool is flawless, so it is helpful to test one assessment against another. For example, it is beneficial to consider P/B ratio valuation along with ROE (return on equity ratio). A high P/B ratio with a low ROE usually indicates overvalued securities and vice versa.

Each market cycle can be different from the last one

Not all market cycles are the same. Historical trends show that the market can remain expensive or cheap (higher or lower value) for more extended periods of time. Also, what is expensive or cheap today may be even more expensive or cheaper tomorrow. One of the ways to deal with this issue is to reduce the asset allocation speed during strong trending (up/down) market.

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Dynamic asset allocation should happen gradually (and not suddenly)

Sudden and significant changes in a portfolio’s asset allocation (potential signs of overconfidence and human bias) may result in unintended consequences and may not achieve the desired results.

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to sum up

While selecting a DAAF/BAF or Multi-Asset Fund Category Scheme, which uses a quantitative valuation model to decide asset allocation within various asset classes, investors may study the process followed by the investment team and consider their Make a better-informed decision based on long-term investment goals.

The author Manuj Jain is Associate Director of Co-Head Product Strategy at WhiteOak Capital Management