The recent turmoil in the financial markets has led many investors to think about their portfolio and whether it is helping them to meet their financial goals. One of the most important aspects of your portfolio is asset allocation—the amount you should invest in various asset classes with the ultimate goal of maximizing return for a given amount of risk.
What is an asset class? A simple description is a group of similar investments that have differing risk and return characteristics than other groups of similar investments. For example, stocks have different risk and return characteristics than bonds, and they do not behave in exactly the same way. When stocks go up, bonds don’t necessarily follow. For this reason, stocks and bonds are not correlated. We seek to create an asset allocation made up of multiple, non-correlated asset classes in order to meet a client’s long-term financial goals.
The returns (and associated risk) of a portfolio are heavily impacted by the asset allocation decision. In fact, a study by Brinson, Hood, and Beebower found that 94% of the difference in return variance among more than 90 pension plans was due to asset allocation—not what particular security was chosen or timing the market.
Another important factor, related to asset allocation, is diversification. Owning a single stock is an example of a non-diversified portfolio. But say you owned two stocks—Apple and Google. Since these companies are both in the technology industry, it still wouldn’t be sufficient diversification. A well-diversified stock portfolio would include U.S. companies, international companies, small companies, and large ones, as well as both value stocks and growth stocks. Similarly, a bond portfolio should include both government and corporate bonds, high- and low-quality bonds, and short-to-long maturity bonds in order to be considered well-diversified.
Ultimately, your asset allocation should be determined based on two things: your personal financial goals and your need and tolerance for risk. Even a well-diversified portfolio invested 100% in stocks is still considered to be high-risk. In some ways, risk tolerance is designed to measure your “pain point,” the drop in value that would cause you to sell your portfolio during a market downturn. Our emotions often tell us to sell when we have suffered a large loss, when the right thing to do is buy. I can’t tell you how many times I have heard people reference selling everything in 2008–09 after losing a large portion of their portfolio; this is often done at the worst time. The right way to approach the issue, if you own both stocks and bonds and stocks fall, is to sell bonds and buy more stocks; this is known as rebalancing. It may seem counterintuitive, but the research shows that it works over the long run. Find an appropriate mix of stocks and bonds based on your appetite for risk (a moderate-risk portfolio is generally accepted to be 60 percent stocks, 40 percent bonds), and work to maintain that mix over time.
It is impossible to know what will happen in the markets over time. Asset allocation allows us to capture the returns of a number of different asset classes and can help to reduce the risk of your overall portfolio. While it isn’t really magic, asset allocation works much better than either a crystal ball or a Magic 8 Ball. We have both in the office, and I can assure you neither works very well.