What is asset allocation?
“Don't put all your eggs in one basket,” this phrase probably says it most succinctly.
How important is Asset Allocation?
Studies have shown that asset allocation decisions can explain more than 90% of the variation in a portfolio's return over time.
Asset allocation involves diversifying and owning various asset classes. These asset classes might include domestic stocks, bonds, international equities, real estate, cash, and several other categories. Ideally, the various asset classes do not move in tandem (highly correlated) with each other. As a group, every asset class carries a unique expected rate of return and level of risk. Typically, the assets will react differently under varying market conditions, such as during a strong economy, slow growing economy, shrinking economy, low inflation, high inflation, etc.
As an example, one asset class may rise in value while another asset class falls over the same period of time.
The ultimate goal of asset allocation is to construct a diversified portfolio that pursues the maximum rate of return in exchange for taking on a certain level of risk.
One way to measure this return to risk proportion is called the Sharpe Ratio, named after Noble prize winner William F. Sharpe. The Sharpe Ratio = (return of the portfolio - return of the risk-free rate) / (standard deviation of returns). The idea is to generate the highest returns for a given unit of risk, i.e., the higher the Sharpe Ratio the better.
Some research has shown that portfolios invested in assets that are not highly correlated with one another may perform better over long-time horizons and carry less risk than portfolios that are heavily weighted toward one type of investment. We might call this, getting a "free lunch"...stronger returns with less risk.
These well diversified portfolios are sometimes referred to as efficient portfolios. Efficient portfolios are designed to pursue the maximum rate of return in exchange for a given level of risk.
What are some ways to go about implementing an asset allocation plan?
Strategic this method establishes and then maintains a specific combination of assets based upon expected rates of return for each asset class.
Investors actively overweight and underweight segments of the market to capitalize on potential short- term market opportunities. When investors reached their short-term profit goals or do not have a strong opinion on segments and sectors they may buy or sell positions in order to return to a core asset allocation
Based with this approach, investors constantly adjust the mix of assets based on their (relative or absolute) valuation. As certain investments get cheaper, and investor will buy more of the asset class and sell as they get more expense. For example, investors may sell existing positions in asset classes that have increased in value in and buy assets that have decreased bringing the mix back to the long-term proportions that are best for the investors risk and return goals.
Rebalancing & Flexibility
The importance of establishing the right asset allocation mix is important, however maintaining it overtime is equally important. Over time as the different assets move up and down it may become necessary to make adjustments to maintain the right proportion. This adjustment process is called rebalancing.
Although it is important to create an asset allocation plan when constructing a new portfolio, it is equally important to assess your allocation over time and remain flexible. Investors can add new investments to fill gaps in their target allocation or to adjust their portfolios as their life situation and goals change.
An annual or quarterly review of your asset allocation plan also gives you an opportunity to review other aspects of their financial plan (risk tolerance, goals, major life changes, etc.). Your asset allocation should support and sync with your overall financial plan.
It is important to understand your portfolio's asset allocation, as it may be the single most important determinate of your portfolio's performance.
-Paul R. Rossi, CFA