How Does Asset Allocation Work?

“There are lies, damned lies, and statistics," the 19th century British politician Benjamin Disraeli once remarked.

In spite of Disraeli’s apparent loathing, statistics have played a vital role in developing modern portfolio investment theory. Indeed, it was the comprehensive use of statistical analysis during World War II that saved the Allies critical time and money in transporting supplies to Europe and paved the way for the Normandy Invasion.

Out of this work on statistical risk analysis during World War II, the modern portfolio theory of asset allocation was developed. In some form or other, statistical analysis is used by the majority of professional portfolio managers.

There are three basic statistical terms you should be familiar with in order to improve your understanding of the scientific concept behind asset allocation.

The mean rate of return is quite simply the average return on your investment. Let’s look at a simplified case in which you purchase a stock that produces returns of –4, 8, 15, and 21 percent over a four-year period. Your mean rate of return is 10 percent annually.

In most instances, like the simple example we have here, your return may well prove to be more or less than the average. The spread of returns around the average is known as the standard deviation.

The importance of standard deviation for an investor lies in the fact that it measures the variability of returns over time. Thus, the standard deviation helps you quantify the risk associated with your investment. It is a statistical fact that 68 percent of the time, the return on your investment will fall between two figures on either side of the mean, which corresponds to one standard deviation.

In our example, if the stock has a mean return of 10 percent and a standard deviation of 12, then 68 percent of the time your return will lie somewhere between –2 and 22 percent.

The wider the spread of results you are prepared to accept, the more certain you can be in predicting them. So if you go to the second standard deviation, statistics show that 95 percent of the time, your actual return should fall within plus or minus two standard deviations of the mean. In our example, this would mean that 95 percent of all returns are likely to fall between –14 and 34 percent.

The final concept you should be familiar with is correlation. If you wish to improve your chances of achieving the average return annually, you need to diversify over a number of different investments with the same potential average return.

If the prices of two stocks always move together, so that when one moves up so does the other, they are said to have positive correlation. Alternatively, if the prices of two stocks always move in opposite directions, they have negative correlation.

The real art of asset allocation is to use the historical statistical information that is available on thousands of investments to build an integrated and diversified portfolio that will meet your expectations.

Keep in mind that asset allocation does not guarantee against loss; it is a method used to help manage risk.