Daily Gains Letter

Two Questions You Need to Ask Yourself to Determine if Your Asset Allocation Is Effective

By for Daily Gains Letter | Mar 22, 2013

220313_DL_zulfiqarInvestment management is considered to be one of the most critical aspects when it comes to investing for the long term. At the end, the goal is to have enough savings to retire comfortably and be stress-free in your golden years. Proper investment management can help individuals achieve their goals while taking adequate risk.

While there are many techniques a person can employ when it comes to investment management, asset allocation is arguably the most discussed one. The myth among investors is that if they keep a certain portion of their portfolio in a specific asset class and hold it, over time, they can produce the optimal return—for example, 50% of their savings in stocks and 50% in bonds.

Asset allocation, at the end of the day, is simply spreading your savings across different asset classes to reduce risk.

It can certainly reduce volatility in an investor’s portfolio and help shield them from major losses; but unfortunately, it can also hinder performance—and over time, it will affect their end goal. Consider this: you have a portfolio consisting of 50% stocks and 50% bonds. Now, if the bond market declines by eight percent and stocks increase by five percent—what’s your portfolio return? The answer: negative three percent.

Fixed asset allocation doesn’t work! There isn’t a number attached when it comes to asset allocation. It depends on an investor’s risk tolerance and their time horizon. Instead of holding a certain percentage of savings in a specific asset, they should focus on constantly balancing their portfolio. Sometimes, one asset class might have higher risk over the others.

In order to check the effectiveness of your asset allocation, ask yourself these two questions: how vulnerable is my portfolio toward a certain asset class, and am I comfortable with what I own?

Question #1: How Vulnerable Is Your Portfolio?

If you hold 90% of your portfolio in stocks and only 10% in bonds, then fluctuations in the stock market will dictate your returns. The portion of the portfolio allocated to a certain asset class depends on the expected performance of that asset. If an investor believes, for example, that stocks will perform better, then they should allocate more to stocks and less to the other asset classes. To give you some idea, according to Gallup, in 2007, investors in the U.S. held 65% of their portfolios in stocks—before the recession struck the U.S. economy and the stock market experienced one of the biggest market sell-offs. Fast-forwarding to 2011, they held only 54% in stock-related investments in their 401(k) or Individual Retirement Account (IRA). (Source: “In U.S., 54% Have Stock Market Investments, Lowest Since 1999,” Gallup, Inc. web site, April 20, 2011, last accessed March 21, 2013.)

Question #2: Are You Comfortable?

As mentioned before, risk tolerance and time horizon are the keys to asset allocation. If an investor doesn’t like taking on risk, then they should focus on assets that don’t carry a significant amount of risk—they may look into holding more government bonds, rather than stocks. On the other hand, some investors might focus on income. In a low interest rate period, risk-averse investors will have to focus on dividend paying stocks, then going after government bonds.

With all this said, investors who are investing for the long term shouldn’t lose sight of asset allocation and should focus on simply taking speculative bets. As the saying goes, slow and steady wins the race. Asset allocation can help you achieve your financial goals while avoiding all the chaos along the way.

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  • Cathal O’Gorman

    To calculate the total return of a portfolio constituting of 50% stocks yielding 5% and 50% bonds which have lost 8% as -3% is to entirely miss the point of asset allocation and diversification, assuming addition was employed. An 8% decline in 50% of your holdings means a -4% return overall. Similarly, a 5% return to the other half of your investments gives a 2.5% return over your whole portfolio. Summing these, your return is actually -1.5%. This can also be calculated, because the allocation is 50:50, as half the difference between -8 and +5, added to -8. For these return levels, (8/8+5), over 61.5% would need to have been invested in bonds for the portfolio return to be -3%.

    Over 2 years, with the original portfolio, your return would be -2.98%. This is a better outcome (although still not welcome!) than investing entirely in one asset class which returned -8% and +5% in consecutive years, which would be a 3.4% loss. Hence, a benefit of diversification! A 60:40 split in favour of stocks, with the same returns and for 1 year, would yield a return of -0.2%, which is 60% of the way from -8% to +5%.

    Consider a portfolio invested 50:50 in stocks and bonds. If the stocks decline 40% and the bonds gain 3%, have I lost 37% of my investment?