A Few Reminders About The Importance Of Asset Allocation

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By: Jim Fink

Seek moderation in all things.
— Aristotle (350 BC)

Let every man divide his money into three parts, and invest a third in land, a third in business, and a third let him keep in reserve.
— Talmud (c. 200 AD–500 AD)

Let’s say you have $100,000 in cash that you want to invest and grow. Should you go to Vegas and put it all down on red for one spin of the roulette wheel? You have a 47.37% chance of doubling your money, after all. Or perhaps you should dump it all into a CD paying 0.5%? Or maybe invest it all in a high-tech stock your uncle’s friend says is a “sure thing”?

Risk and Reward

No, no and no. The goal of investing is to earn as much money as possible based on an acceptable level of risk. Risk and reward are the yin and yang of the universe. They go up and down together, and yet an investor is always seeking the seemingly impossible task of maximizing one (i.e., reward) and minimizing the other (i.e., risk). Doubling your money at the roulette wheel satisfies the desire for a good return, but it fails miserably on the risk parameter. Investing in a CD satisfies the desire for safety, but it won’t provide a large enough retirement nest egg.

Greedy Pigs Get Slaughtered

The key to investment success is “moderation in all things,” choosing a combination of moderate risk and moderate reward that has the best chance of achieving significant wealth accumulation. The means to this end is asset allocation. Keep in mind that asset allocation maximizes your chance of success but does not guarantee it. If the world goes to Hell, no asset class will be safe. As former Federal Reserve Chairman Paul Volcker once said: “You cannot hedge the world.”

Spread the Money Around

The first step in asset allocation is following the old proverb “don’t put all of your eggs in one basket.” No matter what the investment, something can go wrong. If you put all of your money in a single investment and it goes bad, you could lose everything. Large losses must be avoided at all costs because they can irreparably devastate your wealth. Consequently, rather than put your money in a single stock, put it in 20 different stocks. Then, if a stock goes under, it will have much less of an impact on your overall wealth:

Asset Allocation Means Diversification on Many Different Levels

Diversifying the number of investments you own is only the first step of asset allocation, however. Although some risks are specific to an individual security, other risks affect entire industries. Let’s say back in 2006 you bought 20 housing stocks instead of only one. Would your numerical diversification have saved you from the housing crisis of 2008? Nope. When a crisis hits an entire industry, all of the stocks in that industry can go down together.

Consequently, a second step in asset allocation is to diversify the types of investments you own, not just the number. This entails investing not only in different industries, but different geographies, company sizes, styles (e.g., growth vs. value), political statuses (e.g., public vs. private), capital structures (e.g., equity vs. debt), assets (e.g., stock vs. bond vs. cash vs. commodities vs. private equity vs. hedge funds) and even time (e.g., your youth vs. your old age).

How important is allocation? A 2006 study found that more than 100% of investment returns come from asset allocation; active management on average actually loses money.

Every type of investment has its own unique profile, performing well during some economic scenarios and performing poorly in others. As economic conditions change, the relative performances of different investments change. Provided the world does not go to Hell, some investment type will always be performing well based on the economic scenario in place at a given time. By diversifying among many types of investments, you increase the odds that you will benefit from the investment type that does well in whatever the current economic environment proves to be.

If you take a look at historical asset class returns, this constant rotation becomes clear. For example, small-cap growth stocks were the worst-performing asset class in 2000 but the best-performing asset class in 2003. Similarly, long-term bonds were the worst-performing asset class in 2006 but the best-performing asset class during the market meltdown in 2008.

Market Timing Doesn’t Work

Of course, if you knew in advance which asset class would perform the best, there would be no need for asset allocation; you would simply put all your money in the asset class primed to perform best. But in real life, nobody knows the best-performing asset class in advance. The ability to market time successfully over a long period of time is impossible. If you think you can market time, stop reading now. You are a superior life form that does not need to listen to me. But for the rest of you, stick around.

Asymmetry Between Gains and Losses Means Don’t Lose Money!

Why is it beneficial to always be invested in something that is doing well? After all, one could argue that it is OK to take your lumps in one time period as long as you can make up the losses with huge gains in another period. This line of argument fails to understand the asymmetry between gains and losses—losses are much more damaging than gains are beneficial in terms of building wealth.

A portfolio with a constant annual return of 3% could actually create more wealth over time than a portfolio with an average annual return of 6.25% if the 6.25% portfolio includes years with large losses. Consequently, ensuring that your portfolio possesses an asset class that performs well in every economic scenario makes sense because this asset’s gains will neutralize the losses of other investments, thereby smoothing out investment returns and preventing “the big loss.”

Must Beat the Inflation Hurdle

Preventing big losses is necessary but not sufficient. One must also ensure that assets with high expected returns are in the portfolio. Inflation is constantly eating away at purchasing power, and investment returns above inflation are needed to actually grow wealth in real terms.

Investing Only in Stocks May Be Hazardous to Your Wealth

I just read a 2009 paper by University of Colorado finance professor Michael Stutzer that gives a great illustration of this point. He assumes that the stock market will appreciate at a 6% average annual real return, but do so with 40% annual volatility. A 40% volatility level means that chances are two out of three that the actual stock market return in any given year will not exceed -34% on the downside (6% minus 40%) or 46% on the upside (6% plus 40%).

It turns out that the high volatility—i.e., allowing your portfolio return to decline by 34% in a given year—wreaks havoc on the probability of making money in the long run (30 years in this example):

The statistical expected future value of the stock market is the familiar calculation that compounds the market’s initial value at 6% per year. But this statistic is extremely misleading. The median future cumulative return, i.e., the number which has a 50-50 chance of being exceeded after 30 years, will be much lower. In fact, the median cumulative return after 30 years is a loss of around 43% of the initial investment. Thus there is a greater chance of losing money than there is of making anything, much less 6% per year!

Cash May Be Trash, But Not as Part of a Portfolio

Stutzer demonstrates that by changing the portfolio mix from 100% stocks to 50% stocks and 50% U.S. Treasury bills, volatility is reduced sufficiently that the median return becomes a 34% gain.

Here’s the kicker: He assumes that the Treasury bills actually lose 0.1% per year. The benefit of adding the Treasury bills is that they safeguard 50% of the portfolio from those dreaded 34% declines. Then, through annual rebalancing to maintain a 50-50 portfolio split, 17% of the Treasury bills are sold and converted into stock at the lower stock prices caused by the 34% decline. In essence, the combination of adding Treasury bills and rebalancing not only reduces volatility but forces you to buy stocks when they are cheap and sell stocks when they are expensive, which turns a probable loss into a gain.

You heard right—reducing volatility is so important to wealth generation that you can actually increase your probability of making money by adding an asset class that loses money on average! Wow.