The sheer volume of investment information and advice can be so intimidating as to actually prevent savers becoming investors. Identifying an overall strategy can help break through that barrier and asset allocation is a good place to start.
Asset allocation is simply the decision to split the portfolio among broad categories of investments. Those broad categories are typically seen as US stocks, international stocks, fixed income (bonds and other income-oriented investments) and short-term reserves (cash, money market funds, short-term certificates of deposits and short-term income investments). Some advisers now include “alternative investments” (real estate, commodities, partnerships, etc.) as a separate broad category, although at least indirect exposure to these areas is usually found in the stock categories. The type of investment vehicle used is less critical; that is, owning a US stock mutual fund and directly owning shares of General Electric are both part of a US stock allocation.
Committing to and following through with an asset allocation can avoid ending up with a random collection of investments that were chosen because they seemed like a good idea at the time. Compared to managing each investment individually, which is time-consuming at best and maddening at worst, an asset allocation strategy allows an investor to monitor the portfolio much less frequently.
These broad categories have differing degrees of correlation, or the extent to which the movements of two different investments are related or similar. By mixing investments with moderate or low correlation, a diversified portfolio will swing in value less drastically than one that is concentrated in one area. Correlation can change over time, and many investors had a rude awakening during the 2008-2009 financial when all asset classes, with the exception of high-quality bonds, suffered losses in step. Since 1972, there have actually been four brief periods when most asset classes struggled or had big losses. Still, over the long term an appropriate asset allocation will have pieces that zig while others zag.
The real benefit of an asset allocation is that it allows an opportunity to assess whether investment goals will be met. Of course, the appropriate caveat that past performance is no guarantee of future results applies to any projections. Still, financial advisers can generate projections that include a “probability of success” of a particular asset allocation as a simple reality check. The goal is to identify an asset allocation that meets the goals without unnecessary risk. For example, while a more aggressive portfolio (that is, more stocks) may have a higher historical return, it may actually have a lower probability of success because that higher return includes more down periods than a more conservative allocation.
The first level of asset allocation is “strategic allocation” and is the easiest for an investor to embrace. This long-term allocation is a product of desired returns and risk tolerance and also injects a sense of discipline to the portfolio. Because different investment classes perform differently, the investor may “rebalance” the portfolio periodically by selling the better performing investment class and buying the lesser performing class to restore the target allocation. A strategic allocation only changes when there are significant changes in circumstances or goals.
Establishing an asset allocation is not only positive emotionally but it also contributes to long-term performance. Numerous studies have confirmed that around 90% of both portfolio performance and variance in quarterly returns are attributable to the combination of overall market movement and strategic asset allocation. These findings are part of the popularity of index funds, which track a particular market without trying to pick winners and losers. Once an asset allocation is determined, using index funds for each major asset class is an easy and cost-efficient way of implementing the allocation.
The next level of asset allocation is known as “tactical allocation” and this is where investment managers and pundits focus much of their talk and energy. Within the part of a portfolio designated for, say, US stocks, a tactical approach will weigh different factors such as industry sectors and company market value and will shift assets based on market trends. In other words, in an effort to outperform the overall market, tactical asset allocation places bigger bets on certain areas of a market. This can be considered as a form of market timing, and getting that timing right is both notoriously difficult and more expensive than simply indexing the market. The higher cost, of course, is why this approach remains prominent despite its mixed results.
Selecting the actual vehicles in which to invest is not really part of the asset allocation process but is a decision that is part of all investing. For individual stocks and bonds, security selection considers valuation (market price compared to some assessment of underlying value), company fundamentals (a company’s products, markets, management and prospects) and momentum (recent market performance). For mutual funds, security selection considers the manager’s expertise, fund performance compared to the market and its peers and the fund’s composition. Like tactical allocation, security selection receives lots of attention because there are always believers that there has to be ways to beat the market. Anecdotal evidence of a soaring stock like Tesla keeps that belief alive, as does the wealth gained by those who sell the idea. There are certainly security pickers who beat the market but identifying them before their hot streak begins is very hard and most security pickers who beat the market return to average performance in later periods.
Investors can do themselves a huge favor by first deciding how to slice the pie with a strategic asset allocation. As long as the subsequent investing decisions do not involve high costs, they’ll avoid some confusion and will be much more likely to meet their goals.