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Understand Portfolio Asset Allocation: Using Private Credit

Investors face a critical challenge and question of how to balance potential returns and risks in their portfolios. This is where an asset allocation model comes into play, helping investors comprehend the outcomes of different allocations to stocks (equities), bonds (fixed income), and cash.


Understanding Asset Allocation: Balancing Stocks, Bonds, And More


The traditional 60/40 portfolio refers to an investment allocation strategy where 60% of the portfolio is invested in stocks (equities) and 40% is invested in bonds (fixed income securities). This allocation mix is a popular and well-known approach to balancing risk and potential returns within a portfolio due to the uncorrelated nature of these asset classes. History reveals a significant difference in performance and risk. Since 1928, stocks have delivered an average annual rate of return nearly double that of bonds. The average annualized return since its inception in 1928 through Dec. 31, 2022, is 9.82% (1). However, stocks also bring greater volatility, whereas bonds offer portfolio stability but at the cost of lower expected returns. The choice between stock and bond allocations is not straightforward. Below outlines a simple stock-to-bond ratio depending on your investment goals.


Income, Balanced, And Growth Asset Allocation Models


We can divide asset allocation models into three broad groups (1):


Income Portfolio: This allocation model involves a significant portion of the portfolio (70% to 100%) invested in debt securities such as bonds. Bonds are generally considered more stable and provide regular interest payments, making this allocation suitable for investors seeking income and capital preservation. The trade-off is potentially lower growth compared to equity-heavy portfolios.


Growth Portfolio: A growth portfolio allocates a significant portion (70% to 100%) to stocks. This approach focuses on capital appreciation and has the potential for higher returns. However, it comes with higher volatility and risk than more conservative allocations.


Balanced Portfolio: In a balanced portfolio, the allocation typically ranges from 40% to 60% in stocks. This approach aims to balance growth potential (from stocks) and stability (from bonds). It can suit investors who want moderate growth while still managing downside risk.

Traditional 60/40 investment portfolio



Several Reasons Why Investors Consider A Balanced Portfolio

  • Diversification: Stocks and bonds have historically had a negative correlation, meaning that when one performs well, the other may not, and vice versa. By combining these two asset classes, investors aim to reduce the overall portfolio volatility. During periods of market turbulence, the stability of fixed income can help offset potential losses in stocks.

  • Risk Management: Stocks are generally considered riskier assets than bonds due to their higher volatility. Including bonds in the portfolio provides a buffer against extreme market fluctuations as they are generally more stable and less prone to significant price swings, making them a more conservative investment.

  • Income Generation: Bonds, especially government and high-quality corporate bonds, tend to provide regular interest payments. This can be especially beneficial for investors seeking a reliable income stream.

  • Capital Preservation: Bonds are often considered a safer investment compared to stocks. They offer a fixed interest rate and a pre-determined maturity date, which can help protect the principal investment amount. This is appealing to investors who prioritize capital preservation over aggressive growth.

  • Market Exposure: The allocation to stocks allows the portfolio to benefit from potential long-term growth in the equity market.

  • Market Cycles: A mixed portfolio can provide a level of adaptability to changing market cycles. During bullish periods, the stock allocation can capture growth, while during bearish periods, the bond allocation can provide stability.

  • Behavioral Considerations: A mixed allocation can help mitigate the impact of behavioral biases, such as panic selling during market downturns. The presence of more stable assets like bonds can help prevent investors from making impulsive decisions based on short-term market fluctuations. This phenomenon is often referred to as the "loss aversion" bias, a psychological bias where people feel the pain of losses more strongly than the pleasure of gains.


Why Managing Volatility Is Crucial?


It takes more gain to make up for a loss. Let's consider a simple example. Suppose you initially invest $10,000, and the value drops by 20%, resulting in a remaining value of $8,000. To recover from this loss, you would need a 25% gain.

  • ($2,000 loss @ 40%) / ($8,000 remaining value) = 25% gain to be at equilibrium

In this case, you need a 67% gain to recover the 40% loss. This is because the gain is calculated based on the remaining value, not the original value. The loss has diminished your investment base, and any gains are calculated from this reduced amount. This concept holds for more considerable losses as well. The larger the loss, the more significant the gain required to get back to the original investment value. For example, a 40% loss required a 67% gain.


Manage Volatility By Employing A Few Strategies

  • Risk Management: Diversify your investments across different assets and sectors. This can help mitigate the impact of a significant loss in one area.

  • Long-Term Perspective: Focus on the long-term performance of your investments rather than short-term fluctuations. Over time, the market tends to recover from downturns.

  • Emotional Discipline: Recognize and control emotional responses to losses. Avoid making impulsive decisions driven by fear or panic.

  • Reassess and Adjust: Periodically review your investment portfolio and strategy. If your financial situation or goals change, adjust your investments accordingly.

  • Dollar-Cost Averaging: Invest a fixed amount of money at regular intervals regardless of market conditions. This strategy can reduce the impact of market volatility.

Investing always carries some level of risk. By managing risk, maintaining a long-term perspective, and making informed decisions, you can navigate the challenges posed by losses and work towards achieving your financial investment objectives.


How to use private credit in your portfolio

How To Use Private Credit Specialty Finance In Your Portfolio


Asset allocation encompasses more than just stocks and bonds categories. When it comes to the stock component, factors like geography (U.S. vs. international stocks), market capitalization (small vs. large companies), and alternative investments (such as real estate and commodities) should also be considered. Regarding the bonds component, alternative private credit investments (such as specialty finance or trade finance) should also be considered.


Achieving an optimal asset allocation requires striking a balance between potential returns and risks. It is essential to understand that there is no one-size-fits-all approach. Private credit investments can make up a portion of their overall asset allocation. Institutional investors and family offices typically have greater access, but individual high-net-worth investors can also gain exposure through private credit funds.

How to use private credit in 60/40 portfolio


Why Private Credit Is Additive In A Portfolio Asset Allocation?


The distinct attributes of private credit, marked by its capacity to generate income at higher yields, exhibit lower correlation and offer stability through asset backing, rendering it a compelling choice for preserving wealth and fostering capital appreciation.


Higher Yield

As private credit investments typically offer higher returns than public markets, they can enhance the overall yield of a portfolio.


Collateralized Or Seniority

Private credit can play a role in risk management by providing a layer of safety through collateral or seniority in the event of default. Private credit investments are typically structured with specific terms and covenants that outline how the borrower must use the funds and the conditions under which they must be repaid. This can provide greater control over the risk associated with the investment and higher predictability of cash flows.


Diversification / Uncorrelated

Private credit investments are less correlated with the stock market and the overall public markets, which means they can provide diversification benefits to an investor's portfolio. Compared to public bonds, private credit investments tend to have lower interest rate risk for several reasons:

  • Less Frequent Valuation: Private credit investments are typically less frequently marked-to-market compared to publicly traded bonds. Public bonds are valued daily in the open market, which can lead to more immediate and visible price changes based on fluctuations in interest rates. Private credit investments, on the other hand, are often held until maturity or until specific triggers are met, leading to less frequent valuation updates.

  • Negotiated Terms: Private credit investments are often customized and negotiated directly between borrowers and lenders. This allows for greater flexibility in terms, including fixed interest rates, floating rates, and more predictable cash flows. Public bonds, especially those with longer maturities, might have higher sensitivity to interest rate changes due to varying coupon structures and market-driven price movements.

  • Relationship-Based Transactions: There is often a relationship-based approach between the lender and the borrower in private credit. This can lead to more stability in terms of the borrower's creditworthiness and ability to meet their obligations, which in turn can mitigate the impact of interest rate changes.

  • Focus On Income Generation: Private credit investments are often structured to provide regular income in interest payments, making them less sensitive to interest rate fluctuations than bonds, where price changes might have a more pronounced effect on total returns.


How To Use Private Credit In A 60/40 Portfolio?


In a 60/40 portfolio (60% stocks, 40% bonds), private credit, such as specialty finance, trade finance, and other private credit investments, can complement traditional fixed-income investments to achieve higher yield and diversification. Private credit investments can be structured to enhance the portfolio's overall yield and lower volatility. Additionally, private credit investments are less correlated with public markets, which can provide portfolio diversification benefits and potentially reduce overall portfolio risk.

Private credit asset allocation in a 60/40 portfolio

Allocating to private credit in a 60/40 portfolio requires careful consideration, and the appropriate percentage to allocate to private credit can vary based on individual goals, risk tolerance, and market conditions. Remember that the overall impact on your 60/40 portfolio will depend on the size of the private credit allocation and its performance relative to other assets in the portfolio. The table highlights the impact of allocating 10% and 15% to private credit from the total 40% fixed income allocation.










General Guidelines For Using Private Credit


Determine Allocation Size

A common allocation range for private credit in a diversified portfolio is typically between 5% and 15%. However, the precise allocation depends on several factors.

  • Risk Tolerance: If you have a higher risk tolerance and are seeking higher potential returns, you might consider a larger allocation to private credit. Conversely, a smaller allocation may be more appropriate if you are more risk averse.

  • Investment Goals: Consider whether you are seeking additional income, diversification, or enhanced returns. This will influence your allocation decision.

  • Time Horizon: Longer investment horizons may allow for larger allocations to private credit due to the illiquid nature of these investments.


Impact On Fixed Income Allocation


The decision to allocate to private credit should be made in the context of your existing fixed income allocation. Generally, private credit is considered a part of the fixed income category, but it is important to consider that (1) private credit often carries higher credit and liquidity risk than traditional investment-grade bonds and (2) adding private credit can enhance the diversification of your fixed income portfolio by introducing exposure to non-public market segments.


How to use Private Credit in your portfolio


Reference source:




DISCLAIMER

The above charts are for illustration purposes only and are offered solely to demonstrate how a portfolio that allocates a small percentage to direct lending may perform. This chart does not reflect the performance returns of any actual accounts managed by Piton Specialty Finance or any other investment firm. Furthermore, this sample portfolio does not reflect the impact of any investment management fees or other expenses. The performance returns shown above are based upon the actual returns of the MSCI World Index, Bloomberg US Agg Total Returns, and the Cliffwater Direct Lending Index, which are well-known, broad-based indexes. Directly investing in an Index is not possible. No representation is made that any transaction will, or is likely to, achieve results or profits similar to those shown. All information contained herein has been secured from sources that Piton believes are reliable, but we make no representations or warranties as to the accuracy of such information and accept no liability.


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