Why You Need Asset Allocation

“The most important key to successful investing can be summed up in just two words – asset allocation.” -Michael LeBoef, business author and Professor Emeritus, University of New Orleans

I think that anyone who has ever invested has heard the word “diversification.” The idea of spreading your risk or not putting all of your eggs in the same basket is common sense. In portfolio construction we need to take this idea to a higher level. Having a collection of different investments may seem adequate to reduce the odds of them all falling off the cliff at the same. But, if the holdings are too similar, you may find your eggs in similar baskets.

When I was working as a stockbroker I studied and practiced Modern Portfolio Theory and the Prudent Investor Rule.  “A good portfolio is more than a long list of good stocks and bonds. It is a balanced whole, providing the investor with protections and opportunities with respect to a wide range of contingencies.” This is the wisdom of Harry Markowitz who won the Noble Prize in economics and the John von Neumann Theory Prize for his work on Modern Portfolio Theory.

More than just spreading out risk

The theory behind asset allocation is more than just spreading out the risk. Whatever event that may cause a class of securities to go down in value will cause others to go up. When stocks go down there is usually a flight to safety in bonds causing them to go up in value. Conversely, in a bull market or when dividends are more attractive than bond interest rates, bonds would go down as investors pull money and invest in stocks instead. To take this analysis more granular, the Consumer Discretionary sector has historically moved opposite Consumer Staples and Growth stocks against Value stocks. I used to implement a cyclical asset allocation model which invested based on where we were in the economic cycle. More on that in another blog.

There have been a few times that stocks and bonds both went down at the same time; the 1973-74 bear market, in 1994 and in 2008. Asset allocation does not prevent a decline in your portfolio. It is intended to mute the volatility of investing and give you a smoother ride from month to month.

Asset allocation will not be the same for everyone. Your goals, time horizon and risk tolerance are really the foundation of your plan. Asset allocation will be determined by your personal situation.  Investing is a long term pursuit. Bad times will happen. Don’t let that shake you out of the market. For your specific goals and time horizon maybe a higher mix of small cap growth or foreign investments would work best. But, if you don’t have tolerance for extreme ups and downs, you may sell at the bottom before the market bounces back. That’s a normal reaction. The best design is one that fits your goals and personality.

Measuring performance

There are several measures for Modern Portfolio Theory to help us stay on track. Alpha is the measure of return above what should have been achieved for the risk taken or volatility experienced. An alpha of 1.00 means that the portfolio returned the same as the S&P 500. A result of 1.12 indicates a result 12% better. For example, if the S&P 500 had a total return of 10% in a given year then this example portfolio would have a total return of 11.2%. It is an indication of the value that the money manager brings to the table.

Beta is the measure of volatility. The S&P 500 is pegged as 1.00 so a beta of 0.67 means that the portfolio had only two-thirds the volatility of the market. A reading of 1.25, well, that seems aggressive. But, if the alpha is above that number and if you’re ok with 25% more volatility than the market it should work out ok. Just make sure that your risk tolerance matches the type portfolio that you’ve invested in.   

When I was a practicing broker there were times in the mid-2000s when I had an Alpha of 2.00 and a Beta of 0.8 (twice the return of the S&P 500 with only 80% the risk). A client who benefited from this would yell across the room during Happy Hour at the local tavern “Hey, Thomas! Did I make money today?” The answer was almost always “Yes, Chuck, you did!” My bond investors enjoyed an Alpha of 3.00 with a Beta of 0.3 (three times the total return of the Aggregate Bond Index with only 1/3 the ups and downs). One client who benefited brought almost her entire family to me. Four generations of family members. I think only one nephew and one grandchild didn’t move their accounts to me.

Image source: Morningstar.com

A properly allocated portfolio will have the a mix of small, medium and large cap stocks (usually both growth and value) and a selection of bonds from various style boxes ranging from short to long in duration and a mix of credit quality based on your objectives and risk tolerance.

How it may work for you

Selecting an asset allocation model starts with an analysis of your goals compared to your risk tolerance. Any asset class will have similar a reflection of movements both up and down. Asset classes that rise the most in good times usually fall the most in bad times. The same is true for those that don’t make huge gains in good times, they usually turn out to be superstars when they don’t fall much in bad times.

Once your asset allocation profile is established and the strategy implemented, you should not put it on auto-pilot. Rebalancing your portfolio brings your strategy back in line. It’s almost like an automatic buy low sell high system. I always did this for clients quarterly. Here is an example. Let’s say that your allocation calls for 20% Large Cap Growth and 12% Long Term Bonds. The stock market is on an upswing and after one year the stocks going up means that 23% of your portfolio is now Large Cap Stocks and Long Term Bonds have fallen in price and now make up only 10%. In rebalancing, your allocation is brought back to the original percentages. A portion of the stocks are sold at a higher price and the proceeds are used to buy bonds that are now at a lower price. Nothing guarantees against loss, but asset allocation has historically shown to smooth out the bumps.

Take action today

The model best suited for you will change as you move through life and your objectives change, especially when you begin to transition into retirement. Start with a risk tolerance questionnaire and your goals, then an asset allocation review of your current portfolio making adjustments as needed.

Thanks for reading this blog. I hope you found it valuable. Click here to send me a message on what part you liked best or to answer your questions.

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