Your best move in any investment climate
One aspect of human nature runs contrary to good investment management. People look for the “perfect” time to invest. But it is difficult to recognize a moment when markets are stable and predictable, if such a time even exists.
From a long-term perspective, there is no “ideal” time to invest. In fact, successful investing usually requires people to embrace uncertainty. Assuming you have enough time, you should be less concerned with when to invest and more interested in how to structure a portfolio to weather the uncertainty.
Academic research has provided evidence that an investor’s asset allocation decision is the most important element in a portfolio strategy. One landmark study quantified this principle. Released in 1985, the Brinson, Hood and Beebower report culminated an extensive 10-year study of 91 large pension managers.(1) Most importantly, the researchers found that 94% of the performance differential among pension managers could be linked to their asset allocation decision. In stark contrast, only 2% of the performance differential could be attributed to the managers’ market timing decisions and 4% to their security selections. The cost factor was deemed negligible.
Asset allocation involves diversifying among several asset groups to improve total return while reducing risk. (Portfolio risk is normally characterized by total return variance and capital loss.) Your tolerance for risk, investment time frame, financial goals and anticipated need for liquidity will all influence portfolio structure and asset selection.
Remember that there is no free lunch along the risk-return spectrum. A higher targeted return requires a higher risk assumption. Different combinations of investments will produce varying degrees of expected risk and return, based on historical performance standards. You custom-build a portfolio by choosing asset groups that have return characteristics that conform to your risk tolerance. One can further enhance the portfolio’s efficiency by choosing assets which have performed dissimilarly in a given market setting. Although these differences may not appear in a particular year, their statistical dissimilarities may have a positive combined effect on a portfolio over time. Asset allocation considers historical performance to develop a portfolio compatible with your risk-return profile. The resulting plan should tell you how much money to invest in each asset category, the likelihood of achieving stated goals, and how much the portfolio’s total annual return might deviate from its long-term average.
Asset allocation is designed to do more than simply spread risk. It also should attempt to raise total returns by mixing asset groups that will not perform in lockstep. And what does all this do for you? For one, it helps change your investment perspective. As U.S. stocks set new records, bonds drop, interest rates move or international markets lag, you remain committed to your strategy. Your asset allocation model should already account for the inevitable performance swings within various markets.
This disciplined, systematic approach to investing may discourage reactive decision-making and provide the flexibility to capitalize on opportunities unveiled throughout the investment market cycle. While other people are reacting to past events or trying to forecast the markets, your portfolio is positioned to weather market changes.
Asset allocation reflects a highly personalized investment approach because it takes shape from your willingness to assume risk. Furthermore, the strategy can adapt to your changing time horizon. As you move through the financial stages of life, you adjust the portfolio to reflect changes in risk tolerance.
Over the past few years, the financial industry has created tools to help investors plan strategy, evaluate investments and manage their portfolio.(2) Of course, future performance is not certain since asset groups may not follow their historical trends. Furthermore, investors must consider the various risks associated with each type of asset group. However, a well-designed and implemented asset allocation strategy may help reduce certain types of investment risk while positioning assets for enhanced performance over time.
Asset allocation provides a balanced, rational approach to building long-term wealth. When implemented as part of a comprehensive investment plan, the strategy may help reduce portfolio volatility while encouraging a higher investment discipline.
(1) “Determinants of Portfolio Performance”, Brinson, Hood and Beebower, Financial Analysts Journal, July/August 1986. The research aimed to identify the management practices that most greatly influenced portfolio returns. It considered the four most prominent factors influencing a pension manager’s performance-investment policy decisions, individual security selection, market timing and cost management. The research team found that the overwhelming determinant in long-term investment performance was the asset allocation decision-that is, the actual proportion of domestic and international stocks, bonds and cash within a portfolio. In a follow-up study published five years later, the researchers reaffirmed that active management, such as market timing and stock picking, is not a major differentiator of institutional manager returns. (“Determinants of Portfolio Performance: An Update”, Brinson, Singer and Beebower, Financial Analysts Journal, May/June 1991.)
(2) Asset allocation requires systematic monitoring and periodic rebalancing to keep the portfolio mix consistent with an investor’s investment policy. This activity will incur management fees and transaction costs, which can reduce total return.