» Understanding The Benefits of Asset Allocation

Understanding The Benefits of Asset Allocation

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Cathy Pareto

Understanding the Benefits of Asset Allocation
by Cathy Pareto, MBA, CFP®, AIF®

You would not suspect this given today’s turbulent markets environment, but asset allocation actually does work. This much we know– markets are unpredictable in nature, and stock prices are random in their behavior. We also know that market risk can never be eliminated, but certain other risks can. In the world of finance, we separate those risks into two categories, systematic (undiversifiable market risk) and unsystematic risk (ie. company risk, industry risk). Our job as investors, or my job as a financial planner, is to structure portfolios designed to meet a clients specific financial goals and risk preferences. While no “perfect” portfolio exists, many investors will find that a sensible approach incorporates diversification across multiple sources of risk and return. This process is simply known as asset allocation, a concept that we will explore in this article.

Overview

Asset allocation is an excellent tool for addressing the volatility of investment markets. Before we get too far into our discussion, let us first define the term “asset class”, since asset classes play an integral role in this process. An asset class is a group of securities that exhibit similar characteristics and behave similarly in the marketplace. The three main asset classes are equities (stocks), fixed income (bonds) and cash equivalents (money market instruments), although some would argue that alternative asset classes exist too (ie. real estate and commodities). A well diversified asset allocation contains various asset classes that yield positive or negative results at different times. The more asset classes are represented in your portfolio, the better diversified you are. But, as we’ve already established, nothing can guarantee that losses can be avoided during declining markets. It is the extent or depth of those losses that can possibly be minimized with sound portfolio construction.

The Impact of Correlations (1973 to 2007)

In considering new positions to add to a portfolio, assets should be evaluated not by their individual risk or return characteristics, but by their effect on the portfolio as a whole. For a well-diversified portfolio, the risk, or standard deviation from the average return of each stock, contributes little to portfolio risk. Instead, it is the difference, or covariance, between individual stocks’ levels of risk that determines overall portfolio risk. As a result, investors benefit from holding diversified portfolios instead of individual stocks. So, an optimal portfolio can be constructed to maximize return for a given standard deviation (the measure of portfolio risk).

How do we accomplish this? We look for assets who have low correlations to one another. Correlations are a statistical tool that shows how two different investments (or asset classes) perform in relation to each other over some period of time. In other words, we choose investments that move in different directions at different times. Correlations can range between -1 to +1, and anything in between. A correlation of +1, or perfect positive correlation, means that the investments move exactly in tandem. While a correlation of -1 means they move exactly in opposite directions (ie. one asset gains 8%, while the other loses 8%). As an investor, your goal should be to include assets in your asset allocation model with low (ie. 0.50 or less), or negatively correlated assets as depicted below.

US Stock

Source: Morningstar and Dimensional Fund Advisors. U.S. Stocks represented by S&P 500, Bonds represented by Lehman U.S. Long Term Government Index, International stocks represented by the MSCI EAFE Index, Real Estate represented by the NAREIT Equity Index and Commodities represented by the Goldman Sachs Commodity Index.

What about the Risk of the Asset Classes?

Every asset class has a different degree of risk, and varying historical returns as depicted below. Historically, international, small cap, and alternative asset classes like real estate and commodities have demonstrated greater volatility. Should you care? Not really.

US Stock

Source: Dimensional Fund Advisors. U.S. Stocks represented by S&P 500, Bonds represented by Lehman U.S. Long Term Government Index, International stocks represented by the MSCI EAFE Index, U.S. Value represented by Fama/French Large Value Simulated Index, U.S. Small Caps represented by Fama/French U.S. Small Simulated Index. Data from 1973 to 2007.

Despite their higher individual risk, the science of combining these risky assets together in a diversified portfolio is what yields the target results for every investor: lower portfolio risk, higher expected returns. Let’s put this to the test now. Note the portfolio mixes outlined below. The chart begins with a typical retiree portfolio of 60% stocks and 40% bonds in “Portfolio 1”. With each progressing portfolio, new asset classes are added culminating in “Portfolio 4”. Model Portfolio 4 completes this multi-asset class construction by diversifying outside the U.S. and across small and value asset categories.

Allocation Breakdown by Portfolio

Asset Classes

Source: Dimensional Fund Advisors. U.S. Stocks represented by S&P 500, Bonds represented by 5 Year Treasury Notes, International stocks represented by the Fama/French International Large Cap Index, U.S. Value represented by Fama/French Large Value Simulated Index, U.S. Small Caps represented by Fama/French U.S. Small Simulated Index, International Value represented by Fama/French Intl Value Simulated Index, International Small represented by Dimensional Intl Small Cap Index . Data from 1975 to 2007.

Multi Asset Class Investing

A globally diversified allocation harnesses the power of markets, manages the balance between risk and return and provides broad diversification. In the example above, we see that adding the global component reduces the variability in the portfolio’s return due to the lower correlation of international and US risk dimensions. The numbers get even better as you integrate other asset classes, like real estate, commodities, currency, etc. Compared to the original 60/40 balanced strategy, Model Portfolio 4 offers an additional 1.97% annualized return with 0.39% less volatility. Not bad for a day’s
work!

Disclaimer: The information provided in this website is general in nature and is provided for educational purposes only. This information should not be construed as investment advice. Investing in equities involves a serious principal risk, and no assurances can be given that the techniques described here will be successful.