"In theory, there is no difference between theory and practice.
In practice, there is."
Attributed to Laurence "Yogi" Berra, Baseball Hall-of-Fame member, athlete, veteran, and humorist.
Asset allocation is the most critical investment decision faced by individual and institutional investors when it comes to setting long-term risk and return expectations. So, how come it never changes? This article examines the basics of asset allocation and practical considerations for investors.
Asset Allocation Basics
Asset allocation describes how a portfolio is divided between stocks, bonds, commodities and cash. Stocks are partial ownership shares in a public company; thus the phrase “shares of stock.” Stocks are also known as the equity interest in a company. Equity owners take the most risk and have the largest value swings as a company's profitability varies between loss or gain.
For investors, bonds are the loans made to governments, companies, or individuals. As an asset class, bonds are sometimes referred to as “fixed income” because the primary returns from bonds are the interest payments paid to you, not capital gains. Commodities refer to a large group of investments that are sometimes difficult to directly invest in: grains, oil, or metals are good examples. In recent years, new tools have made it easier to get exposure to this asset class.
Blending the asset classes creates portfolios with unique attributes because the asset components are uncorrelated. Harry Markowitz won the 1990 Nobel prize in Economics for his theories on portfolio allocation and diversification. He mathematically demonstrated that diversified portfolios of uncorrelated assets generated better risk adjusted returns than portfolios with poor diversification or assets that are highly correlated.
Portfolio blends with lower stock allocations are typically less risky, so they are given names corresponding to their risk level: fixed income or conservative. As risk level increases, the allocations tend to be called moderate, moderate aggressive and aggressive. There is no standardization of what these phrases mean in practice. As you begin the process of building a portfolio, focus on the asset allocation weights and not the names to determine riskiness of the portfolio.
Most portfolio risk resides in the stock portion of the portfolio. We know this is true because we can look at historical US stock market data over many economic and political cycles to understand their long term returns and the associated risks. The same can be done by examining bond, commodity and cash historical data. By comparing how these asset classes behave over time, we can create a balanced portfolio that will grow over time to fill investor needs. A well constructed portfolio will have several asset classes that are not highly correlated. Remember, if they all go up together, they can all go down together, so we diversify to avoid this undesirable outcome.
Asset Allocation and Risk
There are many techniques for analyzing and managing risk. One simple and intuitive approach is to run different scenarios to measure the size of their outcome. This helps put parameters around what are acceptable and unacceptable risk levels. For example, let's take a group of hypothetical portfolios and identically change the stock and bond returns to compare the overall impact. This should confirm in your mind how bonds can lower risk in a portfolio and why equity heavy allocations are riskier.
It is impossible to construct a foolproof way to deal with risk. There are multiple trade-offs between holding cash, bonds, equities and alternatives. Additionally, the markets behave in non-linear and unpredictable ways. A German general and strategist once said, “No battle plan survives contact with the enemy” (Field Marshal Helmuth Karl Bernhard Graf von Moltke, Chief of Staff of the Prussian General Staff 1857 to 1871). In a sense, your portfolio will experience daily contact with the enemy, where the enemy is the market. What this means is that after formulating a plan, it must be flexible as it encounters the inevitable up and down movements of the market.
Modifying Asset Allocation
To manage losses, there may be a plan for how and when to implement risk reduction strategies. Modifying the strategic asset allocation requires that investors understand the key drivers of markets and then implement changes based on market opportunities and economic conditions. To be specific, investors must look for indicators that affect stock and bond markets, then use them to make decisions regarding portfolio allocation. In times of rising risk and high valuations, the investor should lower portfolio risk. In times of falling risk and low valuations, the investor should increase portfolio risk.
In particular, these are some of the key factors that may affect economic and portfolio growth:
Monetary policy – central banks have specific policies regarding interest rates, regulation and operations that directly affect the banking system.
Fiscal policy – governments dramatically impact a country's growth through tax, regulatory, trade and foreign policy.
Legal environment – laws that protect private property, courts that fairly enforce a constitution create a stable environment for business and investment.
Demographics – population density, age distribution, employment levels, rate of expansion indicate a good workforce and healthy consumer.
There is a misconception that portfolios must be built with a “set it and forget it” mentality. On the contrary, good portfolios are like beautiful gardens; they are the result of work, planning and constant pruning. One of the primary reasons wealthy investors hire financial advisers is to ensure that someone competent and responsible will keep their eyes on the portfolio as market conditions change. Advisers are particularly helpful during bear markets when things are awful. The negative emotions associated with investment losses usually make it difficult to buy at the right time when prices are depressed. Similarly, it is difficult to sell in powerful bull markets when the emotional state is euphoria. Yet, logically, we know we should sell in bull markets and buy in bear markets.
Robert Lloyd, CFA
Thank you for reading this essay on asset allocation. If you would like to discuss the practical implications of this research on portfolio management, please reach out to me at email@example.com.
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Robert Lloyd, CFA® is President, Chief Investment Officer and founder of Lloyds Intrepid LLC, and author of the book Central Markets.
With over 28 years of experience in the financial industry, he has held positions as a trader, analyst, portfolio manager, and wealth manager while working at Invesco, CCM Opportunistic Advisors, and Merrill Lynch. At Invesco, he was lead portfolio manager of the AIM Summit and AIM Constellation Funds, managing approximately $5 billion. In another life, Rob served in the U.S. Navy for 8 years as a Naval Flight Officer flying in the S-3B Viking. For a complete resumé, visit his profile at LinkedIn.
Rob holds a B.B.A. in Management Information Systems from the University of Notre Dame and an M.B.A. from the University of Chicago.
Rob is a Chartered Financial Analyst.
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