Asset Allocation: How To Diversify For Maximum Return

Contrary to popular belief, asset allocation, which refers to the types or classes of securities owned, is generally the most important factor in determining the return on your investments, responsible for about 90 percent of the return according to experts. The remaining 10 percent of the return is determined by which particular investments (stock, bond, mutual fund, etc.) you select and when you decide to buy them. 


 

What is Asset Allocation?

Asset allocation is based on the proven theory that the type or class of security you own is much more important than the particular security itself. Asset allocation is a way to control risk in your portfolio. The risk is controlled because the six or seven asset classes in the well-balanced portfolio will react differently to changes in market conditions such as inflation, rising or falling interest rates, market sectors coming into or falling out of favor, a recession, etc.
Asset allocation should not be confused with simple diversification. Suppose you diversify by owning 100 or even 1,000 different stocks. You really haven't done anything to control risk in your portfolio if those 1,000 stocks all come from only one or two different asset classes--say, blue chip stocks (which usually fall into the category known as large-capitalization, or large-cap, stocks) and mid-cap stocks. Those classes will often react to market conditions in a similar way they will generally all either go up or down after a given market event. This is known as "correlation."
Similarly, many investors make the mistake of building a portfolio of various top-performing growth funds, perhaps thinking that even if one goes down, one or two others will continue to perform well. The problem here is that growth funds are highly correlated-they tend to move in the same direction in response to a given market force. Thus, whether you own two or 20 growth funds, they will tend to react in the same way.
Not only does it lower risk, but asset allocation maximizes returns over a period of time. This is because the proper blend of six or seven asset classes will allow you to benefit from the returns in all of those classes.

How Does Asset Allocation Work?

Asset allocation planning can range from the relatively simple to the complex. It can range from generic recommendations that have no relevance to your specific needs (dangerous) to recommendations based on sophisticated computer programs (very reliable although far from perfect). Between these extremes, it can include recommendations based only on your time horizon (still risky) or on your time horizon adjusted for your risk tolerance (less risky) or any combination of factors.

Tip: Most mutual fund families, brokerage firms and financial service companies offer computerized asset allocation analysis. Unfortunately, many of them, in recommending a specific portfolio of mutual funds or stocks, include only funds in their family (in the case of fund families) or those on which they receive the highest commissions (in the other cases). However, these may not be the best-performing investments. Don't undercut the benefit of a sophisticated asset allocation analysis by allowing yourself to be steered into funds or stocks that are based on biased recommendations.

Computerized asset allocations are based on a questionnaire you fill out. Your answers provide the information the computer needs to become familiar with your unique circumstances. From the questionnaire will be determined:

• Your investment time horizon (mainly, your age and retirement objectives).
• Your risk threshold (how much of your capital you are willing to lose during a given time frame), and
• Your financial situation (your wealth, income, expenses, tax bracket, liquidity needs, etc.).
• Your goals (the financial goals you and your family want to achieve).

The goal of the computer analysis is to determine the best blend of asset classes, in the right percentages, that will match your particular financial profile.
At this point, the "efficient frontier" concept comes into play. It may sound complex, but it is a key to investment success.

How Are Asset Allocation Models Built?

Simply stated, financial advisors build asset allocation models by (1) taking historic market data on classes of securities, individual securities, interest rates, and various market conditions; (2) applying projections of future economic conditions and other relevant factors; (3) analyzing, comparing and weighting the data with computer programs; and (4) further analyzing the data to create model portfolios.
There are three key areas that determine investment performance for each asset class:

1. Expected return. This is an estimate of what the asset class will earn in the future-both income and capital gain-based on both historical performance and economic projections.


2. Risk. This is measured by looking to the asset class's past performance. If an investment's returns are volatile (vary widely from year to year), it is considered high-risk.


3. Correlation. Correlation is determined by viewing the extent in which asset classes tend to rise and fall together. If there is a high correlation, a decision to invest in these asset classes increases risk. The correct asset mix will have a low correlation among asset classes. Correlation coefficients are calculated by looking back over the historical performance of the asset classes being compared.

What Is Right For You?

It's important to be informed about asset allocation so as to avoid the "cookie cutter" approach that many investors end up accepting. Many of the asset allocations performed today take this "one size fits all" approach.
There are all sorts of investment recommendations, but the question is whether they are suitable for you. Regardless of the approach you take, be sure that an asset allocation takes into account your financial profile to the extent feasible.