Value

Asset Allocation Is Not Dead

Value

A February article in the Wall Street Journal discussed the end of asset allocation. In the interim, of course, many undiversified investors have gotten a rude awakening.

The cornerstone of Modern Portfolio Theory, asset allocation is the strategy of dividing up your assets based on a tradeoff of risk and return. The central theme is that based on your own personality, objective, and constraints, you should try to maximize your return for a given level of risk (or minimize your risk for a given return).

As described in the article, investors frequently move away from this method in order to concentrate on higher-return investments. One financial advisor related a story of a client calling to ask why he wasn't doing as well as his son (his son had made 57% last year while the client had only made 20%). The financial advisor had to throw his hands up in disgust. What made it is worse was that the financial advisor had to talk the father into investing in a balanced portfolio to begin with. Originally, the father had only wanted to invest in bonds. Now, he's complaining about only making 20%! Another story in the article described how an individual increasingly was moving money away from his financial advisor to himself so he could manage it and generate higher returns.

What has caused asset allocation to fall from grace is this incredible bull market. With returns of large capitalization, growth stocks (i.e., technology) doing so well, many investors have believed they could achieve better results by concentrating their investments in this category. Over the last few years, this strategy has proved very successful. However, you must consider the risk that's being undertaken. Asset allocation may not provide you with stratospheric returns, but it should lower your risk.

Central to theme of asset allocation is diversification. That is, all assets do not move up or down at the same time. Because they do not behave in the same way at the same time, you lower your risk for your total portfolio by spreading your investments over several asset classes instead of just concentrating it on only one.

As an example, a 100% bond portfolio may be of relatively low risk but if bonds overall perform poorly, then you're sunk. That is why a mix of stocks & bonds is often less risky and generates higher returns then a total bond portfolio.

Gary Brinson, head of Brinson Partners, an institutional money management firm, and one of the leading proponents of asset allocation, argued that this fascination with concentrating your investments goes in cycles. He believes that people are abandoning asset allocation just at the time when they need it the most. While concentrating your investments in high performing sectors may increase your returns in the near term, it will also increase your losses over the long term.

It is exactly at the peak of a bull market when you need asset allocation the most. And this is often when people abandon it because their concentrated investments are doing better than a balanced portfolio. Are we at the top of the bull market now? We may be and we may not be. However, is it more likely that we are today versus 3 years ago? I think the answer is yes. Now is the time to diversify for a market correction. Now is the time to lower your risk and maintain strong returns (maybe not astronomical returns, but strong ones) by using asset allocation.

Julia Curbo manages Portfolios 101, a web site dedicated to portfolio management, personal finance, and retirement planning. A form of this article was originally posted to her Web site in February, 2000.