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Asset Allocation Part 1: What It Is and Why You Need It

[Editor’s Note: This article first appeared as part of our series on Advanced Asset Allocation Strategies. To read the rest of this series, check out: Asset Allocation Part 2: Constructing an Efficient Portfolio, Asset Allocation Part 3: Your Stock and Bond Portfolio Mix and Asset Allocation Part 4: Model Portfolios and Post-Retirement Planning]

Seek moderation in all things.

— Aristotle (350 BC)

 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. 200 AD–500 AD)

Let’s say you have $100,000 in cash that you want to invest and grow.  Should you go to Vegas and put it all down on red for one spin of the roulette wheel? You have a 47.37% chance of doubling your money, after all. Or perhaps you should dump it all into a CD paying 0.5%? Or maybe invest it all in a high-tech stock your uncle’s friend says is a “sure thing?”

Risk and Reward

No, no, and no.  The goal of investing is to earn as much money as possible based on an acceptable level of risk. Risk and reward are the yin and yang of the universe. They go up and down together, and yet an investor is always seeking the seemingly impossible task of maximizing one (i.e., reward) and minimizing the other (i.e. risk). Doubling your money at the roulette wheel satisfies the desire for a good return, but it fails miserably on the risk parameter. Investing in a CD satisfies the desire for safety, but it won’t provide a large enough retirement nest egg.

Greedy Pigs Get Slaughtered

The key to investment success is “moderation in all things;” choosing a combination of moderate risk and moderate reward that has the best chance of achieving significant wealth accumulation. The means to this end is asset allocation. Keep in mind that asset allocation maximizes your chance of success but does not guarantee it. If the world goes to Hell, no asset class would be safe.  As former Federal Reserve Chairman Paul Volcker once said: “you cannot hedge the world.”

Spread the Money Around

The first step in asset allocation is following the old proverb” don’t put all of your eggs in one basket.” No matter what the investment, something can go wrong. If you put all of your money in a single investment and it goes bad, you could lose everything. As I wrote in The Great Investment Truth, large losses must be avoided at all costs because they can irreparably devastate your wealth.  Consequently, rather than put your money in a single stock, put it in 20 different stocks. Then, if a stock goes under, it will have much less of an impact on your overall wealth:

Number of Stocks in Portfolio

Wealth Effect from One Stock Going to Zero

1

-100% (total loss)

2

-50%

3

-33%

4

-25%

5

-20%

10

-10%

13

-8%

17

-6%

20

-5%

Asset Allocation Means Diversification on Many Different Levels

Diversifying the number of investments you own is only the first step of asset allocation, however. Although some risks are specific to an individual security, other risks affect entire industries.  Let’s say back in 2006 you bought 20 housing stocks instead of only one. Would your numerical diversification have saved you from the housing crisis of 2008? Nope. When a crisis hits an entire industry, all of the stocks in that industry can go down together.

Consequently, a second step in asset allocation is to diversify the types of investments you own, not just the number.  This entails investing not only in different industries, but different geographies, company sizes, styles (e.g., growth vs. value),  political statuses (e.g., public vs. private), capital structures (e.g., equity vs. debt), assets (e.g., stock vs. bond vs. cash vs. commodities vs. private equity vs. hedge funds), and even time (e.g., your youth vs. your old age).

How important is asset allocation? A 2006 study found that more than 100% of investment returns comes from asset allocation; active management (i.e., choosing individual securities within an asset class that you judge to be superior to others) on average actually loses money.

Every type of investment has its own unique profile, performing well during some economic scenarios and performing poorly in others. As economic conditions change, the relative performances of different investments change. Provided the world does not go to Hell, some investment type will always be performing well based on the economic scenario in place at a given time. By diversifying among many types of investments, you increase the odds that you will benefit from the investment type that does well in whatever the current economic environment proves to be. 

If you take a look at historical asset class returns, this constant rotation becomes clear. For example, small-cap growth stocks were the worst performing asset class in 2000 but the best performing asset class in 2003.  Similarly, long-term bonds were the worst performing asset class in 2006 but the best performing asset class during the market meltdown in 2008.

Market Timing Doesn’t Work

Of course, if you knew in advance which asset class would perform the best, there would be no need for asset allocation; you would simply put all your money in the asset class primed to perform best. But in real life, nobody knows the best-performing asset class in advance. The ability to market time successfully over a long period of time is impossible.  If you think you can market time, stop reading now. You are a superior life form that does not need to listen to me. But for the rest of you, stick around.

Asymmetry Between Gains and Losses Means Don’t Lose Money!

Why is it beneficial to always be invested in something that is doing well?  After all, one could argue that it is ok to take your lumps in one time period as long as you can make up the losses with huge gains in another period. As I wrote in The Great Investment Truth, however, this line of argument fails to understand the asymmetry between gains and losses — losses are much more damaging than gains are beneficial in terms of building wealth.

I demonstrated in The Great Investment Truth that a portfolio with an average annual return of 3% could actually create more wealth over time than a portfolio with an average annual return of 6.25%, based on the fact that the 3% annual returns were achieved without any large losses. Consequently, ensuring that your portfolio possesses an asset class that performs well in every economic scenario makes sense because its gains will neutralize the losses of other investments, thereby smoothing out investment returns and preventing “the big loss.”

Wealth Generation Requires that You Beat the Inflation Hurdle

Preventing big losses is necessary but not sufficient.  One must also ensure that assets with high expected returns are in the portfolio. Inflation is constantly eating away at purchasing power and investment returns above inflation are needed to actually grow wealth in real terms.

Interesting Facts About Asset Allocation in the World Today

Before getting into the nuts and bolts of how best to allocate assets to achieve a certain level of investment return at lowest risk, it would be useful to provide an outline of what assets are available for the asset allocation process:

Total Investable Capital Market

December 31, 2008

$92.7 Trillion

 

Asset Class

Percentage of Total Capital Market

U.S. Bonds

29.0%

Non-U.S. Bonds

24.7%

Non-U.S. Developed Market Stocks

15.7%

U.S. Stocks

13.0%

U.S. Real Estate

6.4%

Cash Equivalents

4.5%

Emerging Market Debt

3.0%

Emerging Market Stocks

1.6%

Private Capital

1.2%

High-Yield Bonds

0.9%

Source: UBS Global Asset Management

U.S. equities are 75% large-cap and 25% small-cap, 70% growth style and 30% value style, and composed of the following industry sectors:

Industry Sector

Percentage of U.S. Equities

Information Technology

18.8%

Financials

16.4%

Health Care

12.4%

Industrials

11.2%

Consumer Discretionary

10.9%

Energy

10.5%

Consumer Staples

9.8%

Materials

3.9%

Utilities

3.5%

Telecommunications Services

2.6%

World equities are 87% developed markets, 13% emerging markets, and composed of the following countries:

Country

Percentage of World Equities

United States

41.9%

Developed Europe Ex-United Kingdom

18.4%

United Kingdom

8.8%

Japan

8.4%

Canada

4.2%

Australia

3.4%

China

2.3%

Brazil

2.2%

South Korea

1.7%

Taiwan

1.5%

India

1.0%

South Africa

0.9%

Russia

0.8%

U.S. bonds are 39.5% government treasury/agency, 34.0% mortgage-backed, and 26.5% corporate.

Next: Asset Allocation Part 2: Constructing an Efficient Portfolio.

Editor’s Note: For more information on this topic, check out our FREE special report on Asset Allocation Strategies

 


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