This is the first in a three-part series about asset allocation. Today, I’ll grapple with what asset allocation is, how it works and why anyone would use it. Next week, I’ll discuss strategic asset allocation in more depth. Finally, I’ll tackle tactical asset allocation.
What is it?
Asset allocation, in its simplest form, means dividing a portfolio between different asset classes. Asset classes are meant to be investments that perform differently. Technically, an asset class should have a negative correlation (one zigs when the other zags) in order to complement each other. Initially, savers saved cash, investors bought bonds and speculators played stocks. Each of those categories are considered asset classes. Over time, investors realized that stocks aren’t purely speculative, and have added them to their portfolio. Investment managers, whether to add spice to their portfolios, or to offer the appearance of sophistication, have multiplied the number of categories of stocks and bonds that are considered unique asset classes. Some examples are: government bonds, emerging market bonds, corporate bonds, high-yield bonds; dividend stocks, growth stocks, value stocks, large cap stocks, small cap stocks, emerging market stocks, and probably others. Beyond these categories, commodities and real estate may be realistically considered additional asset classes.
How it works
Asset allocation, then, is choosing which classes of assets will be included in the portfolio. Different asset classes have different characteristics and are used to meet different needs. Bonds provide income, as well as guaranteed return of capital. They should be used for investors who need income or who want guarantees. Stocks may provide some income, as well as capital growth. They are suitable for investors who want growth and who have a longer time horizon. Cash is not an investment, and is only suitable for bridging short gaps in income or for making future investment purchases. Real estate is useful for current income, as well as a hedge against inflation. Commodities provide a hedge against inflation. Depending on the goals of the portfolio, then, asset classes should be chosen that reflect those needs. For example, a portfolio that is intended to produce income that keeps pace with inflation would likely invest in some bonds, dividend-paying stocks, real estate and possibly a small amount of commodities.
Why use asset allocation?
Besides matching portfolio characteristics to goals, pension funds and investment funds use asset allocation as a method of diversification to smooth investment returns. For example, given that stocks zig when bonds zag, owning 50% stocks and 50% bonds would create a portfolio that is less likely to experience wild swings in value than a portfolio that is 100% stocks with no bonds. Further, if an investment manager equates risk with volatility, he will tell you that he has reduced risk. Increasing the allocation to bonds (guarantees) will always reduce risk, but not because volatility is reduced. As an example, in a portfolio that is 100% bonds, increasing the allocation to stocks from 0% to 5% may reduce volatility (due to negative correlation), but it has reduced guarantees and increased the possibility of loss of capital.
Asset allocation is an accepted part of portfolio construction. However, because my goals include high income and the potential for capital gains, I have allocated 100% of my portfolio to equities (much of which represents real estate). I don’t mind big swings in value, because fluctuations don’t affect my income. I would only buy bonds if I needed guarantees, or if I had more money than I need for my stock portfolio.