The ABCs of Investing Step 1: Asset Allocation

We begin with “A” for asset allocation, which is the first and most important step in managing your investments. Simply put, asset allocation is the spreading of assets among different asset classes, such as stocks, bonds and real estate. The idea is to allocate assets such that you form a unified portfolio suitable to your risk preferences. Indeed, managing your investment portfolio translates directly into managing risk.

 

From a very broad perspective, the different types of asset classes include the volatile and the nonvolatile. Volatile asset classes have higher variation in returns and higher risk than nonvolatile asset classes and include such things stocks, real estate and hedge funds. Nonvolatile assets include cash, CDs, and bonds. Each individual investor must determine which asset classes to include in his portfolio and at what amount.

Portfolio management is not a new art. In the 1950s, Harry Markowitz, at the University of Chicago, developed a model of portfolio construction based on the interactions of different asset classes with each other. What he found was that by mixing different asset classes you could actually reduce the risk of a portfolio while maintaining the same future expected return. These portfolios are known as efficient portfolios. While each particular asset class or individual security may be highly risky by itself, the interaction of these individually risky asset classes with each other matters more.  Prior to his studies the emphasis on portfolio construction was to determine whether a stock was overpriced or underpriced and then to buy the underpriced stocks.  Modern portfolio theory places the emphasis not on individual stocks but on the portfolio as a whole and how the components of the portfolio interact with each other.

What modern portfolio theory fails to explain is how much risk you ought to take. Which efficient portfolio is right for you? There are three broad ways to determine your risk capacity: ability, willingness, and need. Your ability to take risk depends on many factors, including your age, income, the size of your portfolio. Your willingness to take risk is purely psychological and answers the question “How much money can I lose and still sleep at night?” Your need to take risk depends on your lifestyle, your expenses, and your financial goals and is the most important factor in determining your asset allocation.  While you may have a high ability and willingness to take risk, if your need to take risk is low, why risk it?

The Evidence
A landmark study published in 1986 looked at 91 pension plans over a ten year period and found that 94% of the variation in returns was explained by asset allocation, implying that market timing and selecting individual securities contributed very little to portfolio performance. 

Conclusion
It is an undeniable truth that risk and return are directly related.  Returns come from risk.  They are like a marriage where divorce is not an option. In the context of stocks, asset allocation, determined by your individual risk capacity, ultimately means that not only are we purchasing businesses but we are also purchasing their underlying risk in the hopes of receiving a return.  Now that we’ve established an “airway” for our portfolio via asset allocation, it’s time to make our portfolio “breathe.” Stay tuned next month, when I’ll focus on the “B” of investing.

Asset Class: 
A type of investment with unique risk characteristics (i.e. stocks, bonds and real estate)

Asset Allocation: 
The mix of different asset classes within your portfolio

Modern Portfolio Theory: 
An economic theory which focuses on how investments interact with each other to form investment portfolios which maximize return for a particular level of risk or minimize risk for a particular level of return

Efficient Portfolio: 
A portfolio that provides the greatest expected return for a given level of risk, or equivalently, the lowest risk for a given expected return

Market Timing: 
An investment strategy which changes the types of investments based upon some prediction of a future event, such as a change in the economic cycle or market trends

Volatile Assets: 
Assets which are characterized by large price movements, such as stocks and hedge funds