Asset allocation decisions

Asset Allocation Defined

Capital markets are composed of different types of asset classes. Asset allocation involves dividing an investment portfolio among different asset classes based on an investor's financial requirements. The right mix of asset classes in a portfolio provides an investor with the highest probability of meeting their need.

Each asset class selected has a long-term expected return over inflation, known as the 'real' return. A diversified portfolio will include U.S. and foreign common stock, real estate (REITs), as well as different bond components. See our 30-Year Financial Forecast for a sampling of asset classes that meet the above criteria.

Asset allocation is the most important investment decision an investor will make in their portfolio because it explains most of the risk and return. Not surprising, this view is not without controversy. Some advisors believe that having the right active management style explains most portfolio performance. Academic researchers have looked closely at both sides.

In 1986, Gary Brinson, L. Randolph Hood and Gilbert Beebower analyzed the returns of 91 large U.S. pension plans between 1974 and 1983. They concluded that asset allocation explained 90% of the variance in returns. That conclusion was confirmed by the same authors in 1991 after analyzing a larger database of returns. Roger Ibbotson and Paul Kaplan published a landmark study in 2001 titled "Does Asset Allocation Policy Explain 40%, 90%, or 100% of Performance?” The report confirmed that more than 90% of the variation in portfolio return is explained by asset allocation decisions. It is not the selection of individual stocks or bonds driving performance. It is the asset allocation that makes the difference in the long-term.

How Asset Classes Work Together

Stocks and bonds are the two major categories used in portfolio diversification. The amount that an investor should have in stocks and bonds is based on two factors. First, the allocation is based on the expected return that an investor requires to meet their financial objective, and second, it is based on the amount of investment risk that a person can accept. A successful allocation is one that achieves an investor's financial goals without so much volatility that it causes the investor to make behavioral mistakes.

Asset allocation analysis should include a correlation study between investment types. Correlation analysis shows how the price of one investment has historically moved in relation to the price of another. If two asset classes moved in the same direction at the same time they had positive correlation. If the returns had moved in different directions at the same time, they had negative correlation.

Correlation is not a fixed number. It changes over time and in unpredictable ways. It would be ideal if two asset classes had positive real returns expectations and consistent negative return correlation with each other. Unfortunately, there are no such pairs of investments. A rolling correlation study shows that the correlation between any two asset classes tends to shift over time and in an unpredictable way. Based on past data, we can only loosely predict what the correlation between two asset classes might look like. Click here to see an example of the historic rolling correlation between U.S. stocks and Treasury bonds.

Understanding Risk Tolerance

What is the right asset allocation for an investor? It depends on two issues. First, an investor should design a portfolio so that the expected return satisfies any cash-flow needs today and in the future. Second, any portfolio selected must be within an investor’s tolerance for taking investment risk.

As Markowitz points out, investors cannot ignore risk in pursuit of returns. Risk tolerance is the term used in the industry to explain an investor’s maximum threshold for financial loss. It is difficult to predict the level of emotional stress that an investor can endure before making a hasty decision to abandon their long-term investment plan. Each investor’s asset allocation must be within their tolerance for risk to ensure plan integrity and increase their probability of investment success.

Investment questionnaires are commonly used in an attempt to identify an investor’s tolerance for risk, but they tend to be woefully inadequate. We believe that an investor's tolerance for risk is something that cannot be truly known until it is tested during a prolonged bear market. At Portfolio Solutions, we take a different approach. Rather than using risk tolerance questionnaires, we ask each client to offer their best estimate of their risk tolerance as best it can be known. We do offer our opinion and judgment on the matter if requested, and we will inform a potential client when we believe they are overestimating their tolerance for risk.

Style, Sectors, and Taxes

Asset allocation does not end with a stock and bond allocation. Portfolios are constructed using several different stock and bond sectors and styles, as well as taking into consideration the tax status of each account. 

One strategy we apply is based on the Fama/French Three Factor Model pioneered by Professors Eugene Fama of the University of Chicago and Kenneth French of Dartmouth University. The three-factor model separates stock returns into three categories; “beta,” the risk of owning stocks in general; “size,” the extra risk in small company stocks; and “value,” the value in owning out-of-favor stocks that have attractive valuations. Over the long-term, each of these three separate risk factors has produced its own distinct return premium. These three different risk factors are included in our asset allocation strategies to enhance returns and manage investment risk.

Bond investments are also diversified across several different fixed income risks. Treasury bonds and Treasury inflation-protected securities (TIPS) are the bedrock of the bond portion of an investor's portfolio. The principal and interest is guaranteed by the federal government. Mortgages, corporate bonds and asset backed securities provide extra returns, albeit, with extra risks. The asset allocation and rebalancing of fixed income investments enhances the expected return of a portfolio over the long-term. In a taxable account, tax-free municipal bonds are often substituted for taxable bonds, depending on a client’s tax status.

Taxes and asset allocation are a complex topic with too many variables to discuss in this tutorial. The asset allocation in a taxable portfolio often differs from a non-taxable portfolio based on an investor's tax situation. Taxable portfolios include personal and/or trust accounts where taxes are due on capital gains and income each year. Non-taxable portfolios include IRAs and other tax-deferred retirement type of accounts where taxes are deferred until a later date.  This subject is best discussed one-on-one with a Portfolio Solutions representative as well as your tax professional.

For more information about asset allocation techniques and the theories behind them, see the articles and links in the Research Library. One of the best sources for information on asset allocation is Richard Ferri’s book, All About Asset Allocation.

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