You may have heard the saying, “Simple is not easy.” That saying applies to many things in life, including investing.
In the introduction to their 2009 book, “Asset Allocation for Dummies,” authors Dorianne Perrucci and Jerry Miccolis say that the strategy they support is fairly simple to understand. However, they add, “That’s not to say that sticking with asset allocation is the easiest thing in the world. It can be challenging, and it requires discipline, courage and a little humility.”
So what exactly is asset allocation? In its most basic form, it’s the process of spreading one’s dollars among various types of investments.
But it doesn’t mean just throwing some into this stock or that fund based on a hunch about the economy or a TV commentator’s opinion. Asset allocation is a deliberate process of choosing investments to match risk tolerance and objectives. If something goes wrong in one asset class, such as large-cap U.S. stocks, another should pick up the slack.
Investors in allocated portfolios won’t ever capture the entire return of the best-performing asset class in a given year, but they also won’t suffer the same decline as the worst performer. Because asset classes don’t all move in the same direction at the same time, gains in one typically offset losses in another.
An allocated portfolio travels down the middle of the road, without veering off the edge in either direction. Ultimately, it gets investors to their destination, whether that’s retirement, college savings or some other goal.
Miccolis, CEO and chief investment officer at Giralda Advisors in New York, says the classic one-line description of asset allocation boils down to the concept of not putting all your eggs in one basket.
He says the book focuses on strategic, as opposed to tactical, asset allocation. That means using target allocations for various investments. These are rebalanced on a regular basis to keep the holdings in line with the original targets. Tactical allocation, on the other hand, modifies the holdings according to market conditions.
Before an asset allocation strategy can be implemented, an investor must do a careful review of his or her own unique situation, Miccolis says.
“How much of each different type of asset — whether it’s stocks, bonds, real estate — should you really have for the long term? It depends on you and your personal situation. How risk tolerant you are, what your net worth is, your employment situation, your tax bracket, your family situation, your health,” he says. “All of those very personal characteristics, that are unique to you and your family, should determine your allocation. Not what is going on in the market today, or this week or this month. Not a hot tip you hear, and nothing to do with the economy, even. It’s about your personal situation.”
Often, investors derail their allocation strategies by tinkering with their investment mix based on their opinion about market direction or news about politics or the economy. For example, in recent years, as U.S. stock markets outperformed other developed markets, investors questioned the need for non-U.S. stocks.
“A lot of people abandoned globalizing in their portfolios, which was a big mistake,” says Heidi Richardson, head of U.S. investment strategy at iShares in San Francisco. The firm, which manages a number of exchange-traded funds in various asset classes, is a unit of BlackRock (ticker: BLK).
Thus far in 2015, Richardson notes, indexes of developed markets, such as Western Europe and Japan, have outperformed U.S. indexes. “That’s starting to get more attention now, with people looking at getting some exposure outside the U.S. and not focusing everything on home-country bias,” she says.
In a midyear update, BlackRock offers investors some reminders about staying on course. Among other steps, the firm recommends maintaining a global allocation and resisting the urge to exit the market because of news or hunches.
At its heart, asset allocation is a balance between risk and return. To generate the return necessary to meet an objective, such as retirement, a portfolio must take some risk. However, investors must be comfortable with that level of risk, and understand that their portfolio isn’t likely to beat a common benchmark like the Standard & Poor’s 500 index.
Large asset management firms, such as mutual fund companies, devote considerable resources to testing portfolio strategies. Calculations of expected return, as well as risk measures, are based on numerous historical scenarios.
Mark Hamilton, chief investment officer for asset allocation at OppenheimerFunds in New York, says a portfolio may have a range of outcomes over time. “We look at stress tests,” he says. “We take an existing portfolio and run it through different periods over time. How would it have performed in 2008? How might this have performed in the unwinding of the tech bubble, in the oil crisis or an inflation shock? We want to get more dimensions around what kind of performance you will see.”
From there, professional managers can determine whether portfolios should be tilted more in one direction versus another. This analytical process is very different from an investor bailing out of an asset class based on an opinion.
When running the tests, Hamilton says, “A few of those results would be unacceptable in the first iteration. We then ask what changes we could make to the portfolio to curb some of the outcomes that we might have seen. We take a broader view and recognize that it’s not easy to boil this down to a single number. It’s a range of potential outcomes that you might have seen not only in the past, but also going forward into the future.”
Although portfolios can be fine-tuned to meet specific objectives and risk tolerance levels, it’s not always easy for investors to stay the course when it comes to an asset allocation strategy. Advisors and fund managers say it’s helpful to focus on the reason for investing in the first place, while blocking out the day-to-day noise about market gyrations.
Richardson says investors should ask themselves how much of a volatility-driven decline they are willing to sit through.
“You always think your risk level is one thing, but the second the market goes down and you start to lose money, suddenly your risk tolerance isn’t nearly as high as you thought it was,” she says. “I think of investing as more than asset allocation. It’s really goals-based investing. What is your goal? Is it retirement, paying for college? Because asset allocation is all about building a portfolio that helps you achieve your goal.”
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