Introduction to Asset Allocation

On 01/16/2011, in Investment Strategies, by Jordan Wilson
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The next step in creating an Investment Policy Statement (IPS) is your target asset allocation.

How you intend to invest your capital.

As far as actual investing goes, this may be the most important piece of the puzzle.

This post will provide an introduction to asset allocation.

What is Asset Allocation?

Asset allocation is the process investors use to distribute their investment capital between various asset classes within their portfolio.

The goal of asset allocation is to create a well diversified portfolio. That is, one which effectively reduces the overall portfolio risk while maintaining the expected level of returns.

Asset Allocation Options

Traditionally, capital is allocated between the three core asset classes: cash equivalents, fixed income, and equities. We have reviewed these core asset categories already.

Within these three core classes are many sub-classes. For example, within equities there are many options including sub-classes relating to: a company’s market capitalization; where they are located geographically; what industry they operate in. Within fixed income, sub-classes include: bond maturity date; credit quality of the issuer; currency.

So although there are three core classes in which to divide one’s capital, there are a myriad of choices within each category.

In recent years a growing number of investors are allocating a portion of wealth to other asset classes as well. Real estate, precious metals, venture capital, and derivatives are a few such alternative asset classes. Part of the reason is increased investor understanding about the value of diversification. Part is due to the increasing quantity and quality of cost-effective investments in the non-core asset classes.

In 2011, we will cover these alternative investment categories in a bit of detail.

Diversification

When allocating your portfolio between various investments, your goal is to effectively and efficiently diversify your portfolio.

We have previously covered diversification. I recommend you quickly review An Introduction to Diversification and A Little More on Diversification.

In brief, by adding different investments in your portfolio, you can reduce the overall portfolio risk while maintaining the weighted average expected return.

But effective diversification requires a little more than simply adding different investments to the portfolio. They need to be the right kind of investments.

You need to look at the correlation between assets to find the right type of investments.

Correlation is Key

The correlation between two assets tells how much they will move in tandem.

If they are perfectly positively correlated (correlation coefficient of +1.0), the prices of the assets will move together in lockstep. If they are perfectly negatively correlated (correlation coefficient of −1.0), their prices will move in opposite directions. And if they have no correlation (0.0), the two assets will move completely independently from each other.

Why is this the case?

Each asset class has its own unique risk and expected return profile. Asset classes react to stimuli such as changes in the economy, government monetary and fiscal policy, as well as other factors. Depending on the specific class, these factors will impact in different ways.

For example, consider interest rates. As interest rates rise, (non-real return) bond prices fall.

For successful diversification, investors want to spread out their assets so that the same factor does not affect all investments the same way. When one asset class is negatively impacted by a systematic risk, another asset class should benefit from that same factor.

This provides protection to your portfolio.

Yes, you will not fully participate in strong bull markets in any one asset class. But you also will not suffer the full brunt of any asset class specific bear markets.

If we look at asset classes, traditionally there has been a negative correlation between equities and bonds. As bonds increase in value, stocks should perform relatively poorly. And as stocks rally, bond prices should suffer. By allocating capital between stocks and bonds, you protect yourself when either asset class is underperforming.

For an in-depth review of correlations, please read Diversification and Asset Correlations. There is a lot of information and examples explaining the concept of correlations.

Lower the Correlation, Better the Diversification

In assessing the portfolio risk reduction impact that adding a specific asset will have to your portfolio, you must consider its correlation.

The lower the correlation, the higher its risk-reducing impact.

For example, the correlation between U.S. large cap and U.S. medium cap shares is about 0.90. Very close to perfect correlation of 1.0. The risk reduction benefit from diversifying in this case is poor. As large cap share prices increase, medium cap stocks will rise almost at the same pace. As large caps fall, so too shall medium cap shares.

However, if you allocate between a U.S. large cap and a U.S. bond fund, the correlation is −0.31. So the risk reduction by diversifying is substantial. As large cap shares increase in value, bond prices should fall. But if large cap shares decrease in value, bonds should rise and provide you some portfolio protection.

Correlations Change

The level of correlation between specific assets is fluid to some degree.

Correlations can also shift over time in both directions.

When conducting your periodic portfolio reviews, always check the correlation between your investments. If the correlations have shifted, determine why. It may be a temporary situation or perhaps it is significant and considered permanent. If the latter, you will need to reconsider your asset mix to ensure optimal diversification.

That is an overview on asset allocation.

I will get into more detail on this subject next week.

First will be a look at how asset allocation explains 90% of the variability of portfolio returns.

1 Response » to “Introduction to Asset Allocation”

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