The stock market volatility of late summer should remind investors of the importance of understanding risk and building a portfolio to manage it. Many have found that a globally diversified portfolio has helped mitigate the losses in the U.S. stock market.
Asset allocation is the strategy we employ to help manage risk in a portfolio. The strategy includes four basic steps for an investor:
- Identify how much risk you can accept in your portfolio given your investment time frame, financial resources, wealth accumulation goals and/or income goals.
- Identify various asset classes in proportions that reflect your risk and return profile. The analysis relies on the long-term historical returns of the asset classes and applies sophisticated computer modeling to determine the expected return and volatility range over time.
- Choose the specific investments that offer the purest representation of these asset classes and acquire these through a low-cost brokerage account.
- Monitor the allocation over time and make periodic adjustments to re-establish the original asset mix or make changes based on changing risk tolerance, financial goals and other financial circumstances
Keep in mind that there is no universal portfolio to fit all investors’ needs. Every well-diversified portfolio may be suitable for someone, depending on each person’s investment time frame, attitude toward risk, return expectations and personal investment preferences.
The role of portfolio structure
Academic research offers evidence that an investor’s asset allocation decision is the most important element in portfolio performance. 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) 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.
For the purpose of this discussion, asset allocation and portfolio structure are one and the same. The structure reflects the proportion of various asset classes an investor holds. An asset class is a group of investments with similar characteristics. Basic examples are stocks, bonds, T-bills and real estate. Specific examples within the stock category are small cap, large cap, value and growth stocks, etc. Asset classes have unique risk and return traits. For instance, small cap stocks offer higher average returns than large cap stocks because the market considers them riskier. This also applies to value stocks versus growth stocks. This risk is manifested in higher variation in returns, or volatility, over the short term.
Here’s a basic example to illustrate the key principle proposed in this research. Two portfolios, A and B, have annualized returns of 5% and 15%, respectively. These portfolios may have held different securities and employed different strategies. However, most of the variation in the portfolio returns is due to the behavior of the underlying asset classes. The lower-return portfolio A held securities in asset classes that did not perform as well as those in the higher-return portfolio B. Perhaps portfolio B held more stocks than bonds—or had more small cap and value stocks in the allocation—and it was the return on these asset groups (rather than the performance of the specific securities) that generated the higher returns during the period.
This study and several others build the case for rethinking the activities that add value to an investment portfolio. If the vast majority of a portfolio’s return is due to the asset mix, an investor is best served by focusing on the asset allocation decision rather than stock picking and market timing decisions.
The asset allocation priority runs contrary to Wall Street wisdom, which promotes the belief that portfolio returns are determined by the individual securities held in the portfolio rather than the portfolio’s asset mix. In that world, the difference between portfolio A and B’s returns would be attributed to the managers’ success in researching companies, forecasting market direction and trading skill. Yet, contrary to the managers’ claims of trading expertise, the asset allocation research discussed above asserts that these active management decisions account for a very small portion of the differences in these portfolios’ returns.
Applying the principles
An investor’s risk and return preferences determine the asset allocation within his or her portfolio. A conservative investor may choose a higher allocation to fixed income investments versus stocks due to his lower risk tolerance, shorter time frame and/or income requirements.(2) An investor with a longer time horizon may choose a higher exposure to various asset classes within the stock universe and diversify globally. Between these two approaches is a wide spectrum of possible asset mixes, with each reflecting a specific risk exposure and expected return.
Remember that there is no free lunch along the risk-return spectrum. A higher targeted return requires the assumption of more risk. We custom-build a portfolio by choosing asset groups and combining them in ways that conform to an investor’s risk tolerance. One can further enhance the portfolio’s efficiency by choosing asset classes which have performed less similarly in a given market setting. Although these differences may not appear in a particular year, their return dissimilarities may have a positive combined effect on a portfolio over time.
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 your goals and risk tolerance.
This strategy 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 degree of 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) When structuring portfolios for retirees and other investors with a lower risk tolerance, we use short-term bonds as tools to help reduce the effects of volatility in the stock market. Research has determined that the two risk components in bond investing—maturity risk and credit quality risk—do not offer high enough return premiums to justify holding long-term, low-credit quality corporate bonds. Therefore, our strategy includes holding high-quality, short-term instruments and shifting the available risk exposure to various asset classes within the stock universe, where expected returns have been much higher for the higher risk assumed.