Asset Allocation – What, Why, and How?
Asset Allocation is where investors make their biggest investing mistakes. How you choose to divide your portfolio on a percentage basis is crucial to determining returns and portfolio risk.
What is Asset Allocation?
Asset Allocation is dividing an investment portfolio on a percentage basis among different asset categories. The concept of asset allocation is to combine investments whose asset correlation is low or negative. The idea is that when some asset categories are decreasing, others will be increasing.
By combining different assets with low or negative correlations, the volatility of the portfolio as a whole is lowered. Proper asset allocation can lower risk and increase returns at the same time. This makes asset allocation the highest priority in portfolio risk management.
Why Divide Your Assets?
“Divide your portion to seven, or even eight, for you do not know what misfortune may occur on earth”.
There is no more important investment concept than capital preservation. Most investors invest too aggressively, especially when valuations are not favorable for high returns. An understanding of the importance of capital preservation will cause you to have a plan.
If you keep bear market losses small it’s easier to get back to break even and the move to a positive return. But if you lose a large portion of your portfolio you have lost the investment capital to buy low and make it difficult to recover your portfolio losses.
“A diversified portfolio of investments, each of which is unlikely to produce significant loss, is a good start toward investment success.”
If you lose 50% of your portfolio it takes a 100% gain just to get back to break even. If you held your bear market losses to 10% it only takes an 11% gain to get back to break even.
A 50% gain combined with a 50% loss is not breakeven. You have lost 25% of your investment capital. This means that you want to keep volatility minimized. Portfolio volatility destroys long term performance.
One of the best approaches to lowering volatility is to own a variety of assets. In other words, divide your assets among different asset categories. Owning a variety of assets, especially non-correlated assets, lowers volatility risk. This is why asset allocation is so important.
When one or two asset categories are performing poorly, you may have one or two that are doing well. The idea is to have a portfolio of assets that minimize risk and maximize opportunities for positive returns.
You know the saying “There is no free ride”? There are exceptions. Proper Asset Allocation and Diversification provide benefits that can be harvested with little or no cost.
How to Divide Your Assets
There are an unlimited number of different approaches to asset allocation. In the interest of simplicity I’m going to divide a global investment universe into 7 asset categories. Each of these categories would have sub-categories that would require more detailed attention.
Understanding and anticipating the power of correlation — and thus the limitations of diversification — is a principal aspect of risk control and portfolio management.
While individual investments is the approach I would prefer, small portfolios can efficiently cover the entire global spectrum with 8-12 Exchange Traded Funds. I will provide examples of low cost ETFs for each asset category.
Fixed income examples include Certificates of Deposit (CD’s), U.S. Treasury Bonds, Notes, and Bills; Treasury Inflation Protected Securities (TIPS), Corporate Bonds, and Foreign Bonds. Historically Bonds have had a low correlation with other major asset categories.
ETFs: TLT, IEF, TIP, STIP
Domestic Stocks (Large, Mid-Cap, Small-Cap, and Micro-Cap)
Owning U.S. Stocks is an important asset category for obvious reasons. However, many U.S. residents have too large an allocation. If you aren’t invested in other asset categories (i.e. international stocks) you are missing out on opportunities and not taking advantage of the “free ride” diversification provides.
Foreign Developed Markets Stocks
The value of including foreign stocks is a greater universe of choices and increased diversification. Other regions and countries have different cycles. Their unique problems and opportunities create a wider variety of choices.
ETFs: EWJ, IEUR
Emerging & Frontier Markets
The last couple of decades emerging and frontier economies have gravitated towards free market economics. In general, this has tilted investment capital toward these markets; increasing both the opportunities and their volatility. This is the perfect asset category for ETFs, especially after long periods of price declines.
Commodities & Precious Metals
Commodities & Precious Metals have the advantage of low and sometimes even negative correlations with other investments. They also can be very volatile, providing opportunities and risks.
ETFs: GLD, DBC
Depending on the size of your portfolio, many investors who own real estate directly, including your home, may want to ignore this in their investment securities portfolio. The concept of owning different assets is diversification; and for many investors the real estate they own would be more than sufficient diversification. If not, Real Estate Investment Trusts (REITS) and ETFs are readily available.
ETFs: ICF, IFGL
Cash and Cash Equivalents
Cash provides an asset category with a zero correlation to most assets and provides preservation of capital in bear markets. The zero correlation makes cash an important asset allocation category even during periods of low or zero interest rates. In fact, it may be the most underrated and beneficial asset category in the current environment.
Possible Investments: Any Brokerage Money Market
The importance of asset allocation can’t be ignored. Obviously there is not just one correct approach. Your asset allocation model might be very different from my example.
The point is to have an asset allocation that combines assets in such a manner that lowers your overall portfolio volatility. While it may be more fun to pick individual investments, your asset allocation decisions will have the largest effect on your long term returns.
Make asset allocation your first priority, then pick the individual investments which fit within your target asset allocation. During the entire process keep capital preservation foremost in your mind.
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While Arbor Investment Planner has used reasonable efforts to obtain information from reliable sources, we make no representations or warranties as to the accuracy, reliability, or completeness of third-party information presented herein. The sole purpose of this analysis is information. Nothing presented herein is, or is intended to constitute investment advice. Consult your financial advisor before making investment decisions.