Let every man divide his money into three parts, and invest a third in land, a third in business and third let him keep in reserve. Talmud (c. 1,200 – 500 AD)
What is asset allocation?
How you choose to allocate your assets between asset classes (refer to this article on what is an asset class?) is probably the most important decision you will make when it comes to determining whether or not over time you will earn your required rate of return. Emphasis on the ‘that you will make’, because the most important determinant of your return will be how the overall market performs which is outside of your control.
Put simply individual assets within the same class tend to move in line with the class of assets to which they belong. In financial jargon they are highly correlated and it is the performance of the whole asset class that matters.
Unfortunately, this “asset allocation” decision is one that most retail investors don’t spend nearly enough time thinking about.
Why is asset allocation important?
It is important simply because different classes of assets have different correlations to each other (refer to Asset Correlations Explained – A Simple Portfolio). Assets which are negatively correlated to one another work together to produce a lower risk portfolio, with less volatility and in the long term higher returns.
According to Ibbotson Associates research “in aggregate 100% of return levels come from asset allocation before fees and somewhat more after fees. This is a mathematical truth that stems from the concept of an all inclusive market portfolio and the fact that active management is a zero sum game. The fundamental truth is somewhat boring; therefore, it is often lost in the debate even though it is by far the most important result.”
However investors are not going to get much emotional support from the media if you intend to implement an asset allocation approach. The financial media is almost exclusively focused on the very short term, what/how the markets moved this week. But you don’t want to let a journalist manage your money! The information reported by journalists is designed to get your attention, not necessarily make you money.
Asset allocation improves investment returns because of the benefits of diversification (read Asset Allocation Explained – A Simple Portfolio).
Why don’t investors follow a long term asset allocation strategy?
The answer is easy: emotion. Think about it. Rebalancing your portfolio under an asset allocation approach means taking from the investments that are making you money and reinvesting into the investments that are losing money. Emotionally, it doesn’t make sense.
Why asset allocation works
The fundamental idea behind asset allocation is that a portfolio made up of assets whose returns are negatively correlated to each other will do better than a portfolio whose assets all plummet to the floor at the same time.
Following an asset allocation strategy encourages adding, or re-balancing, into the sectors that are out of favor. This promotes the basic idea of buying low. If you were to re-balance your existing portfolio, you would be taking some of the gains from the sectors that have done well and allocated into the sectors that are under performing.
This promotes the basic principle of selling high. “Sell High/Buy Low” – isn’t that something we all want to accomplish?