- Though less exciting than hunting for the market’s next big winner, asset allocation is an important step in the effort to enhance diversification and reduce risk.
- Research shows that asset allocation has an impact on returns and the variability of returns.
- The stock tumble of late 2018 is a good reminder that allocation should always be a priority.
Someone dreaming about a well-earned Caribbean vacation probably focuses on the fabulous weather, the gorgeous beaches, and the wonderful golf courses to play. One rarely considers the less glamorous details along the way — packing bags, dealing with airport parking, and waiting through long security lines. The dream is in the destination.
So it is with many investors. They dream about market-beating returns and finding the next hot growth stock that will turbocharge portfolio gains, and not so much about the fundamental factors that have historically delivered alpha.
Asset allocation is one of those fundamentals. Most investors can’t work up much interest when it’s time to discuss portfolio allocation, but it’s been shown to be a primary determinant of returns over time. The wrong asset allocation could put you on course to an unwanted outcome.
Allocation versus market timing and individual security selection
Most financial advisors can quote the conventional wisdom in the Gary P. Brinson, CFA, Randolph Hood, and Gilbert L. Beebower (known as “BHB”) report on asset allocation. In a nutshell, the study concluded that a portfolio’s asset allocation explained most of the volatility and variability in returns over the long term.
Why asset allocation matters
Improving risk-adjusted returns is our goal, and we pursue it with a distinctive dynamic approach.
This original research has been revisited and challenged many times. In 2000, Roger Ibbotson and Paul Kaplan addressed a perceived weakness in the study in that it focused only on return variability as opposed to overall performance. Their paper, “Does Asset Allocation Policy Explain 40, 90, or 100 Percent of Performance?” found that asset allocation accounted for just 40% of variability, but 100% of absolute returns. Additional industry studies have added more nuances to these findings while forming a general consensus about the benefits of proper asset allocation.
In other words, the investor who gets asset allocation right within a broadly diversified portfolio is likely better positioned to achieve greater risk-adjusted returns over time than one who focuses solely on security selection and timing the market.
Opening the allocation conversation
The fourth quarter of 2018 may have been a wake-up call for investors accustomed to the mostly steady gains of a 10-year bull market. After reaching records in September 2018, the Dow fell 11.31% and the S&P 500 dropped 13.52% for the fourth quarter, although the drop was even sharper prior to a year-end rally. For the year, the S&P 500 was down 4.38%, even as the economy grew at the fastest pace in years. This was a near correction. As difficult to predict, and even more severe, are bear markets. The average bear market sees a drop of nearly 40%, and predicting the next one — which could be right around the corner — is difficult, to say the least.
However, other asset classes fared far better in 2018 despite the U.S. stock market correction. The Bloomberg Barclays U.S. Aggregate Bond Index finished the year mostly flat, with a 0.01% gain; convertible securities registered a gain of 0.15% (ICE BofAML U.S. Convertible Index); and cash rose 1.87% (ICE BofAML U.S. 3-month T-Bill Index).
Asset class divergence can also last for longer periods. During the “lost decade” of 2000 to 2010, the S&P 500 had average annual returns of -0.95% (10 years as of December 31, 2009), while bonds measured by the Bloomberg Barclays U.S. Aggregate Index returned 6.33% over the same period — and the MSCI Emerging Markets Index exceeded 10% average annual returns. Investors with portfolios focused exclusively on domestic large caps were left behind, while those with more diversified portfolios continued to grow their wealth. It’s a lesson that shouldn’t be lost on investors who lived through the final weeks of 2018.
Describe the value of diversification
Economist Harry Markowitz once said diversification is the only “free lunch” in finance — a way of describing that investors get the benefit of reducing potential volatility by combining assets that may move in different directions, all while keeping their money invested rather than moving to the sidelines. While diversified portfolios still face a risk of negative returns, market history suggests that diversification can help reduce the frequency and severity of losses. The free lunch concept of diversification was foundational to Markowitz’s Nobel Prize-winning work in modern portfolio theory. It’s a concept that many investors can understand.
The key to maximizing the free lunch is to reconcile the capacity for risk with the time between today and when the assets will be needed. An example is asset allocation for retirement savings. People early in their careers have time on their side and can afford to take more risk by allocating more to equities to seek growth. Those in their 40s and 50s can’t rebound from a 40% drop nearly as easily because they have fewer years for their savings to rebound, and so a common strategy is to allocate increasing amounts to bonds.
The key is to keep investors focused on goals. When stocks are galloping along, it’s easy to get caught up in seeing which companies are doing the best. But investors don’t necessarily need the most glamorous investments. They need a portfolio that can help them achieve their financial goals with the amount of risk that they find acceptable.