The division of assets within an investor’s portfolio is generally accepted to be one of the most important decisions to be made. Widely accepted academic research demonstrates that approximately 90% of long-term investment returns can be traced back to asset allocation.
From the highest level, asset allocation is simple. How much of your portfolio should be invested in stocks, and how much should be in more conservative investments such as cash, CDs and bonds. Rules of thumb abound here: 100 (or 110, or 120) minus your age is the figure that should be in stocks, etc. Personally I believe that this initial decision of asset allocation should be determined as a result of long term financial planning and a personal review of one’s need to take risk, ability to take risk and desire to take risk.
But beyond this initial slice of the portfolio pie chart, the waters get muddy. First, investors have to decide how to define asset classes (is natural resources an asset class or a sector? What about technology?), then decide which asset classes should be included in the portfolio. Lastly, how much exposure to the asset class should you have?
Just for fun, go ahead and answer those three questions about the following:
- US Stocks
- Growth & Value
- Mid Caps
- Small Caps
- Foreign Small Caps
- Emerging Markets
- Frontier Markets
- Real Estate
- Commodities/Natural Resources
- “Alternatives” to include:
- Sector Rotation
- Tactical Allocation
- Managed Futures
- Hedge Funds
- Private Equity
- MLP’s and pipelines
And that is just for the stock side of the portfolio. We won’t even go into the myriad of options facing bond investors.
Now, there is ample evidence to suggest that some overweight (compared to the market portfolio) to small caps and value strategies will enhance long-term returns (although such allocations do increase risk). And we have terabytes of historical data to use to help with forward-looking guidance. And even still, we are faced with an unknown future.
There are many professional advisors and software vendors promising “optimized” and perfectly allocated portfolios. They do this by either using 1) historical data about how asset classes have behaved in the past or 2) their own forward-looking (read: fortune-telling) predictions about how these asset classes will behave in the future. To do this correctly, they must have accurate information regarding the future returns, volatility (risk) and correlation between all included asset classes.
Have you sensed what is wrong with this approach? The future is fairly certain to be different than the past, and unlikely to fit perfectly with any one person’s or company’s prediction of what is to come to pass.
It is so much more important that investors develop a long term investment policy and STICK WITH IT than splitting hairs over whether a 10% or 15% allocation to small caps or a 20% or 30% allocation to foreign stocks is “best” going forward. When we get down into the nitty-gritty details, there is no way to predict which asset allocation will provide the best risk-adjusted returns this year or for the next ten years. But we can certainly have a say in our behavior. Second-guessing your asset allocation decisions because they “aren’t working” this year will cost you much, much more than you can ever add with a 2% tweak here and there.