Asset Allocation

asset-allocation

I utilize a proven investment approach that the average investor doesn’t use, but beats most of the pros over the long run – if you follow it faithfully. It takes a little bit of work to set it up, but very little cost and expertise. Once it’s in place, it takes a relatively small effort to manage. It gives you a high likelihood of reaching your investment goals.

The core principle of this approach is passive management, utilizing different asset classes. As you will see, this approach is known to more sophisticated investors and advisors and is backed by years of data. You’ll want to look at this section, as well as Selecting Your Assets, and  Designing Your Portfolio to get the whole picture.

Asset Allocation

I describe asset allocation in this way: Divide your investment portfolio into different asset classes that diversify and complement each other, while providing the level of risk and return that will meet your goals.

Source: Gibson, “Asset Allocation,” 2008, p. 198

Source: Gibson, “Asset Allocation,” 2008, p. 198

Let’s look at the ancient Talmud strategy and how it can be implemented today. Land is real estate. Business is stocks. Reserve is bonds. The table below shows you the returns of a portfolio that uses very basic asset allocation across these three asset classes (stocks, bonds and Real Estate Investment Trusts (REITs)). Note that in the Bear market of 2000-2002, large company US stocks lost 47%, while the Talmud strategy gained 5%. This demonstrates how diversifying across asset classes can protect an investor in a down market. While stocks languished, bonds and real estate securities gained.

“Let every man divide his money into three parts, and invest a third in land, a third in business and a third let him keep in reserve.”
– Talmud (c. 1200 BC – 500 AD)

Bear Market Performance

Source: Gibson, “Asset Allocation,” 2008, p. 198

Source: Gibson, “Asset Allocation,” 2008, p. 198

The chart below shows another example, using various stock/bond combinations in a portfolio over the period 2008-2009 which included the big bear market of 2008, with the Wilshire 5000 equity index dropping 37%. During this time period all of the portfolios that had an allocation to bonds would have produced a portfolio that performed better than the stock only portfolio. By holding a combination of stocks and bonds, you smooth out your returns and avoid big losses.

Asset Allocation Makes Returns Smoother

The astute reader may ask: Why not just hold stocks for the long run and ride out the drops, since stocks tend to have higher returns than other asset classes over time? This is a reasonable question. The answer is:

  1. Most investors cannot psychologically withstand strong bear markets such as 2008 and 2002. They will be compelled to sell their stocks while everyone else is doing so.
  2. Avoiding large losses is a key tenet of successful investing. Let’s look at the math: If you lose 35% on your $100,000 portfolio in a year, you are left with $65,000. To get back even, you need to gain 53.8% ($35,000/$65,000). Assuming historical stock market returns of about 9%/year going forward (highly optimistic!), and you are still brave enough to keep 100% in stocks, it will take you almost six years to get back even. A bit like the tortoise and hare fable.
  3. Over the long run, an asset allocation approach can produce portfolios with higher returns and lower risk than the stock-only portfolio.

The chart below illustrates this last point. Notice portfolio A, consisting of all stocks, had a compound annual return of a little more than 11% and a standard deviation of returns (risk) of about 17%. Compare that to Portfolio ABCD which has an equal dose of US stocks, non-US stocks, REITs and commodity linked securities. ABCD has a higher return and lower risk.

Source: Roger C. Gibson/Asset Allocation, page 182.

Source: Roger C. Gibson/Asset Allocation, page 182.

In addition to a better risk-return tradeoff over the long run, these diversified portfolios reduce risk of loss in a given year:

Source: Gibson, “Asset Allocation,”2008, p. 198

Source: Gibson, “Asset Allocation,”2008, p. 198

The magic in this is due to combining non-correlated assets. So when stocks drop, other assets such as commodities, REITs or bonds might be rising, eliminating or reducing overall portfolio losses.

As we discussed earlier, the efficient frontier is the curve that depicts the returns and risk from each unique combination of assets in a portfolio that yields the highest unit of return for a given unit of risk. By including more assets (beyond just stocks/bonds) that have low or negative correlation, you can get more return for a given unit of risk, i.e. you achieve a more “efficient frontier” of risk/return combinations.

“If we don’t have something that hurts at a given time in our portfolios, then we’re not properly diversified.”
– Robert Scherer, Graystone Consulting, A Barron’s Top 100 Financial Advisor

The chart below depicts correlations among various major asset classes. This gives you an idea of how asset classes can help diversify and balance a portfolio. For example, looking at the first row, you see that US Stocks are negatively correlated with US Government Bonds. You saw that in the examples above.

A correlation of 1.0 indicates perfect correlation, while a correlation of 0.0 indicates no correlation.  A negative correlation indicates that when one asset is going up, the other is going down. Emerging market bonds have virtually no correlation (0.2) with US Government bonds, so adding those to a US bond portfolio provides effective diversification to a portfolio. Natural resources (precious metals, oil, agricultural and other commodities) have relatively low correlation with US, Foreign and Emerging Market stocks (0.5, 0.6 and 0.6 respectively). These are just a few examples that demonstrate how diversification across asset classes can dampen portfolio volatility and risk, while still providing good returns.

However it should be noted that correlations vary over time and cannot be predicted. They may not provide the diversification benefits that they have provided in the past. For example, this held true in the 2008 bear market when commodities declined about the same amount as stocks.  Investing is about probabilities, not precise mathematical certainty. That is another reason it is wise to diversify your assets in a balanced way.

Asset Allocation with Passive Management

As I discussed previously, I believe passive management is superior to active management. There are a few exceptions where one might want to utilize active management or something close to it. More on this later. My approach is to select asset classes and use indexed investments (mutual funds or ETFs) to buy those asset classes, rather than try to select individual securities within each asset class. In the next section, I discuss each major asset class and my views on which ones to utilize in your portfolio.

Go to the Next Article: Selecting Your Assets

No comments yet.

Leave a Reply