Allocation, allocation, allocation. The most commonly cited advice doled out by financial institutions and advisors the world over. Proper asset allocation in an investment portfolio cannot be overstated. In working with investors from many different walks of life, we have found it surprising how few people understand the origin of diversification, and more importantly why and how it works. Over the next few weeks we will be exploring the origins and implications of well executed asset allocation in investment portfolios, starting this week with the introduction to our article series, A New Spin on Asset Allocation.
Asset Allocation is one part of the overarching strategy suggested by Modern Portfolio Theory (MPT), by far the most prolific portfolio management strategy in the financial industry. MPT suggests that the first step to finding the right investment strategy for an individual is to first assess their appetite for risk, or downside. MPT goes on to dictate that an investor’s risk tolerance should then inform asset allocation - the mix if different types of investments in a portfolio. Additionally, that asset allocation should be diversified among different types of assets (asset classes), and further into asset sub-classes in order to create the most efficient portfolio for the investor’s comfort level. Essentially, the risk in a portfolio can be balanced by utilizing different asset classes which have different downside risk amounts and generate returns in dissimilar market conditions, thus creating a much more predictable rate of return for investors.
What does that mean for you?
Typically, if an investor desires more growth in their portfolio, they will designate a higher allocation into stocks (equities). While the upside is attractive, equities also have a higher associated downside risk – the potential of a security to suffer a decline should market conditions become unfavorable. In contrast, if an investor desires more security or stability, or a predictable stream of income from their portfolio, they are generally directed towards bonds and other debt instruments – which typically experience less volatility and act as a reliable foundation in a diversified portfolio. This approach can alleviate some of the pain of crashes or down trending markets, but also caps returns below a 100% equity strategy due to the lower return rate of such securities.
A relationship amongst asset classes exists that can serve to protect, grow, and balance a portfolio all while maintaining focus on the specific goals of a particular investor. Somewhere in the middle lies the foundation of MPT and the magical allocation that the financial industry has been in search of for decades. Asserting some balance in a portfolio creates a good synergy due to the fact that equities often move in one direction while bonds move in the other, rarely experiencing negative volatility at the same time. This is referred to as having low or no correlation, and provides stability in the multitude of market environments when both types of assets are present in a portfolio. The negative side of this relationship is that an investor is usually limited to specific times where a portfolio generates growth, typically only when stocks are up. If stocks go down, they generally pull down the marginal gains in bonds, albeit not as severely, and the overall portfolio trends downward. This leads to a question we as financial professionals hear often, “When the market is down, do I have to keep a lot of low-return investments in my portfolio to offset the downside in the market?”
Take a look at the following scenario and illustration for further explanation.
Let’s say we’re looking at the stock of two textile companies who sell seasonal goods – beach towels and blankets. Let’s also say that in our version of the world there is a perfect counter-cyclical relationship between buyers of beach towels and blankets (i.e. a purchase of one means there is no purchase of the other). If we charted this activity it would look something like this:
As you can see from this illustration, if an investor owned stock in only company blue, they would wind up with a similar rate of return as the orange company, however the experience would be hard to stomach for most investors due to the amount of volatility in each as a standalone investment. If we observe the line in the middle of the chart, we see that the result of having a 50% allocation in each stock is much more predictable and stable.
While the previous example is great in theory, it is almost impossible to synthesize such a portfolio as there are no investment vehicles that have such a perfectly counter-cyclical relationship to each other. A more pertinent real world example below highlights how stocks and bonds intertwine, the S&P 500 Index and the Barclays US Bond Aggregate Index, and illustrates one of the problems with many investor’s portfolios.
As you can see, while bonds aren’t subject to the same kind of downside volatility as stocks, they have much lower expected returns. Thus, while the overall portfolio has less significant ups and downs, the end result is a significantly reduced amount of growth in the overall portfolio when compared to an all-equity strategy.
So if the wonderful upside of stocks carries significant risk and its counterpart, bonds, offers very little upside but a high degree of protection, where does that leave us?
This chart exposes the primary issue with how Modern Portfolio Theory is implemented in the financial industry today, which is the issue of choice. Most investors are either limited in choices to only equity or bond investments. To achieve the most efficient allocation for an investor’s risk tolerance, additional opportunities are needed. While investment vehicles focused on asset classes beyond stocks and bonds exist, they are mostly reserved for large institutions, most will find options outside of such choices difficult to access, difficult to understand, and exorbitantly expensive. Thanks to advances in technology investors now have access to entirely separate markets beyond the standard stock and bond market, that give them the ability to generate returns in almost any market condition and even consistently outperform the stock market.
Stay tuned to the site next month as we continue our series on Asset Allocation, where we will delve into the missing asset classes and why investors should consider the impact they can have in their own portfolios.
Sortino, Frank A. and Van Der Meer, Robert (1991) Downside Risk, The Journal of Portfolio Management, 17, 27-31
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