Know the Art and Science of Asset Allocation
Asset allocation is a major determinant of investment returns, according to financial economists.
This popular investment strategy balances returns with risk by dividing a portfolio among various types of investments. The most popular asset classes are equities, fixed-income and cash equivalents.
However, there can be advantages to traveling off the beaten asset allocation path. Iconic research published in 1986 in the Financial Analysts Journal set the stage for the important contribution of asset allocation to an investor's ultimate returns.
[See: 10 Reasons Investors Shouldn't Panic About Stocks.]
Why asset allocation matters. Choosing a variety of asset classes promises that your investments will include some winners and some losers, which vary over time. The less correlated the asset classes, the greater diversification benefit you'll receive. This has the advantage of smoothing out your investment returns, on both the upside and the downside.
An often-overlooked benefit of asset allocation is that it saves you from yourself. Amid a bull market, as stock prices soar, you might be tempted to go "all in" to the stock market. That would set you up for a shock during a market crash like 2008, when the S&P 500 lost 36.55 percent.
Stephen J. Taddie, managing partner at Stellar Capital Management in Phoenix, compares asset allocation to playing a round of golf, where you need different clubs to play the course well.
How asset allocation works. Your investment returns typically reflect those of their related asset classes. So, for a simple portfolio of 50 percent U.S. equity, 30 percent international equity and 20 percent bonds, your returns will correspond to those of the underlying investment categories. For example, for the trailing 12 months, ending Sept. 30, the S&P 500 earned 17.9 percent, the FTSE all world (international), ex-U.S. index earned 2.1 percent and the Bloomberg Barclays U.S. 10+ year corporate bond index lost 2.4 percent.
It's likely that if your investment proportions approximated the stock and bond portfolio above, so would your returns with an approximate 9.1 percent gain. The positive equity returns offset the losing bond values.
Yet, asset decisions are more complex than choosing a handful of index funds. The greatest benefit to your investment portfolio comes from including less correlated assets. However, discovering less correlated asset classes is difficult and asset correlations change over time.
[See: 8 Stocks to Buy for the Fourth Quarter.]
For the greatest benefit from your diversification, you need assets that aren't highly correlated. In other words, "The performance difference between a large-cap 'blend' manager and an allocation between a value and a growth manager is negligible," says Scott Sadler, founder and president at Boardwalk Capital Management in Atlanta.
In 2017, emerging markets and developed markets were roughly 80 percent correlated, while today their correlation has fallen to approximately 40 percent, according to State Street Global Investors. James Picerno's economics website, the Capital Speculator, reports a recent 1 percent correlation between commodities and bonds with a 30 percent correlation between international bonds and global real estate, underscoring the great distinction between some market corners.
For your core allocation, Sadler suggests inexpensive index funds, such as an S&P 500 holding. Then, focus on market zones where you can add value such as small cap, micro-cap, and real estate.
Understanding that investment allocation is important doesn't tell you how to apportion your investments or which asset classes to choose, says Benjamin Halliburton, chief investment officer at Tradition Capital Management in Summit, New Jersey. He recommends going beyond the typical stock and bond investments.
"The uber-wealthy are not keeping all their money on that one boat," he says. "They have already split up their assets into multiple boats that are navigating different courses to the destination." Halliburton suggests reinsurance, real estate, timberland, infrastructure and alternative lending investments for his clients.
Wealthy and institutional investors travel off the beaten asset allocation path, Sadler says. He suggests solar farms as an infrastructure, diversification play. Sadler likes the cash flow and equity-like returns of this niche investment.
Halliburton claims sophisticated asset allocation generates income, protects your portfolio and might offer higher returns than the typical stock and bond portfolio.
Asset allocation isn't for every investor. Not all financial pros adhere to a diversified asset allocation plan. Warren Buffett, the Berkshire Hathway (ticker: BRK.A, BRK.B) chairman and arguably one of the world's best investors, asked the trustee of his estate to invest in government bonds and a low-cost S&P 500 index fund. This approach would slash fees and mirror the 9 percent average returns of the stock market and those of safe government bonds with only two asset classes.
[See: 10 Reasons Warren Buffett Is a Better Investor Than You.]
Kevin Caron, senior portfolio manager at Washington Crossing Advisors in Florham Park, New Jersey, points out the "averaging" drawback of asset allocation. "Often, asset allocation relies on index funds and these funds generate the average performance of an index," he says. "When this happens, investors have given up whatever return might come from active investing."
The bottom line. In the end, strategic investment allocation can dampen losses, not eliminate them. When the market goes down, so will your investments. But with greater diversification your portfolio losses will be tempered, you'll remain calmer and be able to buy assets on sale after a market drop.
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