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The Importance of Asset Allocation

Updated on May 10, 2012

Proper Asset Allocation

When building and investment strategy we often hear the term “diversification” Yet and equally important concept is “Asset Allocation” It has been shown via numerous studies that the proper allocation can account for better than 90% of long term investment returns.

So what exactly is Asset Allocation…The purpose of producing an asset allocation model is to produce market like investment returns with substantially less volatility. Certain asset classes historically have a low correlation to each other and hence behave and move in opposite directions. All assets rise over extended periods of time. But by combining different asset classes together, you traditionally reduce volatility. This is premised on the assumption that you will continually rebalance your portfolio according to a changing set of financial conditions. There is also a need to pay a great deal of attention to the underling investments used to meet this allocation. However for the sake of this analysis we will look less at specific solutions, but rather at asset classes and how they correlate.

Imagine setting sail in a ship to go from one place to another. It is not likely that the journey from one lighthouse to the next would be a direct path in a straight line. Investing can be quite similar. Much like the tide of the ocean redirecting your ship constantly, macroeconomic events can redirect your portfolio. It is important to have a course charted and to properly navigate it. However, the first premise that one must accept in building a proper allocation is that the timing of short term market volatility is simply an exercise in futility. Portfolio construction must begin with the assumption that you will own multiple asset classes at all times in an attempt to reduce volatility. Therefore eliminating any one asset completely, regardless of your convictions, must be ruled out.

So what are these asset classes…Broadly speaking, they are stocks, fixed income, commodities, real estate, and cash. However they can be broken down into sub-asset classes. More importantly, it is the correlation of these assets that is important. So let’s take a look at how these assets have behaved in recent history. The last decade has been one of greater than average volatility. Often times this has been referred to as the “Lost Decade” This is often a reference to the fact that as of this writing, the Dow Jones Industrial Average as well as the S&P 500 Index are largely in the same place they were 10 years ago. However, these are two stock indexes that are exclusively large cap equity investments. A sound asset allocation would not consist exclusively of US large cap stocks. First let us take a look at a more broadly based track record of investment returns. We will look at both the last 10 years, as well as the ten years leading up to the major market correction and recovery of 2009.

10 year returns............................................................2000-2009.........3/31/2012

S&P 500 Index (Large Cap Stocks)..................................-.09%.................4.12%

S&P Small Cap 600 Index (Small Cap Stocks)..................3.5%.................7.58%

S&P 400 Mid Cap Index (Mid Cap Stocks).........................5.0%................7.70%

MSCI EAFE Intl Index (Intl Stocks).....................................1.6%.................5.65%

MSCI Emerging Markets Index (Emerging Mkt Intl)...........10.1%..............14.13%

Barclays Aggregate Bond Index (Blended FI Index)...........6.3%................5.8%

ML US High Yield Index (Junk Bonds)................................6.5%................9.09%

S&P GSCI Commodity Index (Basket of Commodities)......7.1%................4.79%

Dow Jones US REIT Index (Real Estate)..........................10.6%...............9.35%

What you can clearly see, is the decade while below historical averages…was far from lost. A novice investor will look at the data above and often simply purchase the highest performing assets based on historical return. This is precisely what you don’t wish to do. By combining all of these assets together you will find long term returns that are closer to market like returns with less risk.

Let’s look at an actual example.

Portfolio A is assumed to be 90% US Stocks & 10% International Stocks. Portfolio B is constructed in a ratio of 60% stock market based investments (10% Intl Stocks), with the remaining 40% in fixed income and cash equivalents. Please note that this is not referencing any one investment fund, but rather benchmark data assuming quarterly reallocation.

Returns.............2008...........2009...........2010...........2011.......Ten Year Avg Return

Portfolio A.........-37.40%......26.80% .....14.26%........0.74%.........4.33%

Portfolio B.........-21.24%......19.42%......13.44%........2.06%.........6.63%

What we learn from our results is that the increased volatility of placing 100% of your assets into the stock market doesn’t always produce the highest returns. While it should be noted that during decades of more traditional performance, the 100% stock based “Portfolio A” will likely produce a long term higher resulting average return. However the difference is often nominal. The more important point is simply a similar end result with significantly less long term volatility. This is of a paramount importance in the structure of a personal financial plan, were income distribution to a retiree can be greatly impacted.

The Importance of rebalancing…One key component in an asset allocation model is that of rebalancing the portfolio. To liken this to our example above referencing a ship sailing on the sea, although you’ve plotted a course, the tide has taken you adrift. The same will happen to your investments if not reallocated. As in the example above…a -21.24% decline in 2008 is hardly palatable. Most of that decline is a result of stock based investments. While the Fixed income portion of your portfolio rose by a factor of 7.94%. This means you are now over weighted in fixed income investments and underweighted in stock based investments. Thus you must sell a portion of what has gone up and buy a portion of what has gone down. This sounds like a simple principal. Yet how many reading this commentary were inclined to buy stocks in 2008 ???

Experience has shown us over the years that most investors tend to be understandably emotional about their investments. However that is not a recipe for long term investing success. We have always said that “Nobody cares more about your money than you do”. Yet that can be a handicap rather than a benefit. Investing is a science…yet not a precise one. It is never as simple as it seems. This is largely due to the fact that this science must play out over a long period of time. Many investors grow impatient, fearful or sometimes overzealous. Successful investing requires not only knowledge, but some other very key variables. Among them are the time to manage money effectively, the discipline to make unemotional decisions, and clearly you must have an interest being actively involved in the investment process.

At Landmark, we subscribe to the notion that there are additionally more advanced ways to bring down portfolio volatility beyond the more basic concepts explained above. Furthermore there are some important concepts that must be understood around specific investments solutions. Yet the first step is having a fundamental understanding of how asset classes correlate. However each client circumstance is unique and needs to be addressed as such.


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