What is asset allocation?
Asset allocation is a technique that determines the mix of asset classes (small stocks, big stocks, emerging markets, government bonds, corporate bonds....) that provides the highest probability of achieving a given return rate. For example, if you need a return of 12.2%, asset allocation might result in a mix of 40% large stocks, 40% government bonds and 20% emerging markets. You should achieve the maximum rate of return for the least amount of risk at a given level of risk.
Asset allocation is different from security selection, which is the process of selecting the securities you will actually invest in for each asset class. For instance, choosing to put 40% of your portfolio in long-term growth stocks is an asset allocation decision; choosing to buy 100 shares of ATT stock is a security selection decision.
Why perform Asset Allocation?
Diversification lets you cut risks sharply without sacrificing return. Of all the decisions an investor makes, effective asset allocation has the greatest effect on your total return. Effective asset allocation distributes a portfolio's assets so that there is an optimal tradeoff between risk and return.
Several studies have shown that your asset allocation decision is the most important factor affecting your long-run risk and return. In fact, 93% of long-term performance results from asset allocation. The specific choice of securities accounts for only 7% of long-term total performance.
The Efficient Frontier
There are many possible asset allocations. The optimal asset allocations are calculated along a line graph using expected returns, standard deviations, and covariances of each asset class to plot what is called the efficient frontier graph. The efficient frontier represents those portfolios that provide the maximum expected return at each incremental level of risk.
Levels of risk are determined by your time horizon, investment philosophy, and age. The key to successful investing is finding the asset allocation that offers the best possible return without exceeding your tolerance for risk.
What is investment risk?
Investment risk is a measure of how far the actual return can be expected to vary from the expected return in any given year. We calculate his by measuring how far the actual return has varied from the average return over an historical period.
Risk is measured using a number called standard deviation. Standard deviation marks the range within which the actual return will fall 67% of the time. For example, a portfolio with an expected return of 10% and a standard deviation of 20% will have a 67% chance of generating a return of between -10% and +30% in any single year. To calculate a 95% probability, just calculate returns using 2 standard deviations. So the same portfolio with an expected return of 10% and a standard deviation of 20% has a 95% probability of achieving a range of returns of -30% to a +50% return. (2 * standard deviation)
What is the risk/return tradeoff?
The risk/return tradeoff is one of the cornerstones of financial theory. In short, it means that to increase your expected returns you must accept increased risk or volatility. This makes sense when you think about it. Investors will tend to flock to those investments that offer the best return with a given level of risk. The higher return these investors want, the more risk they are willing to accept.
CAVEAT: HIGH RISK DOES NOT GUARANTEE HIGH RETURN. Just as with more risk you may achieve higher returns, with more risk you could also lose more. Markets do not just go up and businesses do fail, products become obsolete, market shares erode, competition squeezes prices, economic conditions change, consumer tastes change etc... So ju st because you decide to take more risk with your portfolio doesn't mean that your returns will automatically be higher. The risk/return tradeoff is a general truism in the investment industry but it doesn't ALWAYS work out that way.
What about market timing?
Many investors believe that by accurately predicting changes in the economy they can shift their investment strategies to outperform the market. This approach is called a market timing strategy.
The key phrase here is "accurately predicting" which turns out to be much more difficult than it sounds. Remember, thousands of professional money managers are paid millions of dollars to spend their lives trying to outguess the market. Despite the awesome brain power focused on the problem, almost 90% of professional money managers underperformed the market during the 1980s.
One study has shown that market timers need to predict upturns and downturns accurately 80% of the time for market timing to pay. Consistent asset allocation policy held for the long-term offers the best chance for the investor to achieve steady returns.
ASSET ALLOCATION STRATEGY
An asset allocation strategy provides diversification among different investment categories, such as equity, debt, cash, international investments and real assets, such as gold and real estate.
By allocating a fixed percentage of the total portfolio to each category and then maintaining those percentages with subsequent investments, the investor realizes an averaging effect. This benefit occurs because he or she invests more in the categories that have relatively under performed in the preceding period. Often these categories gain strength in the later stages of the market cycle.
AN ALLOCATION EXAMPLE
The illustration below shows how a $100,000 allocation plan could work. Assume an investor had made the following investments and was considering re-allocation based on the increased current portfolio value:
Fund Type Original Current Value Desired
Mutual Fund 40,000 48,000 40%
Mutual Fund 40,000 44,000 40%
Mutual Fund 20,000 21,000 20%
Total Funds 100,000 113,000
Forty percent of the current value, $113,000, is now about $45,200 and 20% of that is about $22,600.
Following our proposed model, we reallocate the money among the funds to achieve the original percentages - $2,800 out of the stock fund. Of this, $1,200 would be placed into the bond fund and $1,600 into the gold fund to achieve the original balance.
ADDITIONAL INVESTMENT ALLOCATION
The same principles apply when new money is invested into the account. Assume the same $113,000 account value. Our investor now has a $10,000 quarterly deposit ready to be allocated to the program ($10,000 + $113,000 = $123,000). Forty percent is $49,200 and 20% is $24,600.
Following the Investment Allocation model, we would then allocate $1,200 to the stock fund, $5,200 to the bond fund and $3,600 to the gold stock fund, thereby returning the portfolio back to the original desired allocation percentages.
Important benefits can be realized by following this asset allocation method: disciplined investing, averaging down by investing more in the categories which have appreciated less and maintenance of the asset mix determined to be appropriate for the investor's individual objectives and prudent diversification.