Asset allocation is probably something you’ve heard about in the game of investing. But do you truly understand it, and how you are supposed to be using it? There’s no exact dictionary definition for Asset Allocation. It’s Finance 101 jargon, sure, but it’s typically a key component of portfolio health and few really understand it. The average investor knows what an asset is (money or possessions that have economic value) and even what allocation is (the act of distributing or spreading something around), but the two together are lesser known, often wrongly defined and haphazardly applied in retirement portfolios.
Put simply: Asset allocation is a means to balance risk and reward by adjusting the percentage makeup of a variety of core asset classes (e.g., stocks, bonds, cash) across the investable landscape in an investment portfolio. Asset allocation is a way to implement the universally popular idea of diversification, which is the concept that encourages adding a higher number of investments within a specific asset class and portfolio. But it is not the same thing.
To understand the role of asset allocation in sound portfolio construction, consider what it looks like relative to its peer concept of diversification:
Example of:
Diversification: investing in 20 technology stocks versus one technology stock
Asset Allocation: investing in five asset classes in three separate areas of the world versus investing only in U.S. stocks and bonds
Assuming common retirement goals, portfolio construction will employ both of these concepts with asset allocation operating as a foundational guiding principle.
Putting a variety of asset classes together in one portfolio helps to determine a portfolio’s rate of return variability. Note, I said “rate of return variability,” not simply “rate of return.” Different asset classes have varying correlations to one another; meaning they don’t necessarily all move in lock step together. Thus investors aim to construct their portfolio with several different asset classes, in an effort to absorb big market swings (rate of return variability) while, ideally, still generating reasonable performance.
How asset allocation came about
A modern idea of asset allocation was introduced in a 1991 academic paper titled “Determinants of Portfolio Performance II: An Update.” The paper covered a study of pension fund portfolios from 1977 to 1987. Its findings suggest that “investment policy” (now referred to as “asset allocation”) explained 91.5 percent of the variation of total investment returns in a portfolio over a period of 10 years. It showed that two pension funds with the same percentage mix of stocks, bonds and cash would be expected to have a similar standard deviation or historical volatility, over time.
You might interpret the results to suggest that over 90 percent of a portfolio’s returns are dictated by the mix of asset classes. This is incorrect. Asset allocation drives how volatile overall returns will be. Volatility measures the riskiness of an asset. For example, stocks are more volatile than Treasury bonds, and high-quality corporate bonds are less volatile than REITs (Real Estate Investment Trusts). Volatility is typically measured by a standard deviation for each asset class. For example, a risky asset class like stocks should typically move 15 to 20 percent up or down in any given year whereas bonds should typically move up or down 3 to 5 percent per year.
Asset allocation in practice
In practice, you could also think of asset allocation as “high risk high reward blended with low risk low reward.” If a portfolio is built around investments that move independent of one another, then these can smooth performance and bring returns in line with the risks of the collective assets in the portfolio. We’d call these assets uncorrelated — one class might be up on a day when the other is down. And by allocating assets across a variety of classes, investors may insulate themselves from risk that lacks commensurate return.
Applying the concept of asset allocation over time should, theoretically, make your portfolio more “efficient.” This means you have the right mix of stocks, bonds, REITs, commodities and other investments that provide an optimal rate of return for the level of acquired risk.
Asset allocation does not ensure that you earn a maximum rate of return … but that's OK! Asset allocation by definition is a blend of asset classes, and there is no way that these together will outpace the maximum performance potential of any one high-flying asset class. What it does is help maximize risk-adjusted return. Everyone wants the nearly 600 percent returns the S&P 500's financial sector has delivered since 2009. But those portfolios, if all-in on financial stocks to get that return, would have sustained the nearly 90 percent beating the sector took on the run up to March of that year.
Your approach to asset allocation depends on your appetite for risk. Can’t stomach volatility, or have a shorter investment horizon? Consider investing in lower standard deviation asset classes like bonds. Have the stomach and time frame for higher volatility and potential return? You might favor a heavier mix of equity-like classes including stocks and REITs.
The bottom line on asset allocation
Asset allocation is likely one of the most important forms of diversification: It’s the diversification of asset categories. This can offer less erratic performance and act as an emotional buoy when certain asset classes take a hit. As September 2018 marked the 10-year anniversary of the collapse of Lehman Brothers bank, it is a reminder that keeping sane is critical to “staying the investing course.” Overwhelmed investors tend to overreact. They’ll become defensive, reducing exposure to strong, risk-adjusted returns. Or they’ll move too aggressively to risky asset classes.
Even if your portfolio isn’t perfectly optimized every day, allocation over five-plus asset classes can go a long way toward better risk adjusted returns. Don’t burn yourself out trying to time your entrance and exit in and out of asset classes. A sustained balance is your friend.
Wes Moss has been the host of “Money Matters” on News 95.5 and AM 750 WSB in Atlanta for more than seven years now, and he does a live show from 9-11 a.m. Sundays. He is the chief investment strategist for Atlanta-based Capital Investment Advisors. For more information, go to wesmoss.com.
DISCLOSURE
This information is provided to you as a resource for informational purposes only and should not be viewed as investment advice or recommendations. Investing involves risk, including the possible loss of principal. There is no guarantee offered that investment return, yield, or performance will be achieved. There will be periods of performance fluctuations, including periods of negative returns. Past performance is not indicative of future results when considering any investment vehicle. This information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. This information is not intended to, and should not, form a primary basis for any investment decision that you may make. Always consult your own legal, tax, or investment advisor before making any investment/tax/estate/financial planning considerations or decisions.
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