There are 10 principles for establishing and maintaining an optimal asset allocation. With them, you can build an appropriate portfolio for your situation.
Principles can be described as the beginning, the foundation, the source, or the essence upon which things build and expand. They are important in investing because they bring structure to your financial plan. There are 10 cornerstone principles of asset allocation and each one plays a vital role in establishing and maintaining a truly optimal asset allocation. By practicing these principles, you can build an appropriate portfolio for your situation. Keep in mind that asset allocation does not ensure a profit or protect against a loss.
Cornerstone Principle 1: Market Efficiency
Market efficiency is the golden principle of all asset allocation cornerstone principles. Without some degree of market efficiency, we would not employ asset allocation and would probably focus instead on security selection. Fortunately, our financial markets are highly efficient and are becoming even more so as information technology gets better with time.
Underlying asset allocation are two highly influential and well-known investment concepts: modern portfolio theory and the efficient market hypothesis.
Modern portfolio theory says that neither investors nor portfolio managers should evaluate each investment on a stand-alone basis. They should instead evaluate each investment based on its true ability to enhance the overall risk-and-return trade-off profile of a portfolio. Moreover, modern portfolio theory states that when an investor is faced with two investments with identical expected returns, but different levels of risk, that investor would be wise to select the investment that has the lower risk.
The efficient market hypothesis, in a related way, says that security prices are fair and reasonable because they fully reflect all available public and nonpublic information that might affect them. As a result, it is the amount of risk that investors are willing to accept that explains their real investment performance over time.
Cornerstone Principle 2: Investor Risk Profile
Your optimal portfolio is designed based principally on your willingness, ability, and need to tolerate risk. Consequently, once your risk tolerance is determined, your optimal asset mix can then be established in order to maximize your portfolio's return potential. This concept is expressed as the risk-and-return trade-off profile. Personal preferences toward risk assumption play a vital role in determining your willingness to tolerate risk. For example, two different investors with the same level of wealth and the same specific goals and needs would each have a different preference for assuming risk.
Your ability to tolerate risk is highly contingent on your investment time horizon and level of wealth. Generally, the longer your investment time horizon and the greater your level of wealth, the more risk you are able to tolerate because people with longer time horizons and people with greater levels of wealth have more room for error in achieving their specific goals and needs.
Cornerstone Principle 3: Identifiable Financial Goals
Asset allocation is the strategy of dividing the assets within a portfolio among the different asset classes, seeking to achieve the highest expected total rate of return for the level of risk you are willing and able to accept. As a result, knowing why you are investing and what you are attempting to accomplish is the vital first step. You cannot hit a target you are not aiming for.
When identifying your specific goals and needs, focus on quantifying and prioritizing them. Simply saying you need enough money to fund a college education or support yourself in retirement is much too ambiguous and not especially intelligent. Identifying that you need $25,000 per year for four years in tomorrow's dollars or $75,000 per year in retirement expressed in today's dollars is more appropriate. Lastly, when identifying your specific goals and needs, ensure that they are realistic, achievable, and measurable.
Cornerstone Principle 4: Time Horizon
Time horizon plays a significant role in estimating asset class returns, risk levels, and price correlations. Accurate forecasts are essential to building an optimal portfolio. The primary use of time horizon is to help determine the portfolio balance between equity assets and fixed-income assets and cash and equivalents. All else being equal, the longer your investment time horizon, the more equity investments and less current income-producing investments you may consider holding. Conversely, the shorter your investment time horizon, the more current income-producing investments and less equity investments you may consider.
One common risk that needs to be addressed over the long term is purchasing power risk, or the loss of an asset's real value due to inflation. Equity investments may provide the best hedge against this risk. As a result, the longer your investment time horizon, the more you may consider allocating to equity assets. In the short term, volatility is often a concern. Fixed-income investments may provide the best hedge against this type of risk and may be considered in your portfolio as well.
Cornerstone Principle 5: Expected Total Return
Expected total return is simply your forecast of total return for each asset class and asset subclass during the future holding period. While past performance does not guarantee future results, using historical rates of return in lieu of estimating expected rates is not only quick and easy but also a prudent approach used by many financial professionals.
Once your risk tolerance has been identified, you then design your portfolio to maximize your expected total rate of return for the given level of risk you are willing, able, and need to assume. This task cannot be accomplished without an estimate of future returns. This is the essence of the risk-and-return trade-off profile. Without a clear understanding of expected total rates of return for each asset class, there is little hope of maximizing a portfolio's potential performance and building your optimal portfolio.
Cornerstone Principle 6: Risk-and-Return Trade-off Profile
The trade-off between investment-specific risk and return is central to the application of asset allocation theory to an investment portfolio. Risk and return are unequivocally linked, and one simply cannot earn an excessive return while assuming a corresponding low risk. In basic asset allocation theory, the higher your risk tolerance, the higher your potential returns. You should not assume higher risk for the same potential return that a less risky asset may offer. The message here is that you need to build a portfolio with the maximum expected potential total rate of return given the level of risk you are willing, able, and need to assume.
Cornerstone Principle 7: Correlation
The term correlation refers to how closely the market prices of two investments, or, in the case of asset allocation, the prices of two asset classes move in relation to each other. Although not always the case, most securities within an asset class or asset subclass tend to move together over time. Of course, there are always exceptions.
Your aim is to allocate investments to asset classes and asset subclasses that do not move in perfect lockstep with each other. The greater the difference or the lower the correlation that two asset classes move together, the more attractive they are for investment purposes. Since some asset classes experience strength at one time whereas others experience strength at other times, it may be appropriate, depending on your tolerance for risk, to allocate among multiple asset classes at all times. Investing in multiple asset classes may allow you to avoid serious market and portfolio weakness. Lastly, by investing in multiple asset classes with low correlations, you enhance the risk-and-return trade-off profile for your portfolio.
Cornerstone Principle 8: Diversification
It is important to apply the principle of diversification in order to minimize risk in a portfolio. The task of diversifying a portfolio should be addressed after completing the process of allocating among asset classes and asset subclasses. Diversification is the process of investing in a significant number of not-too-similar investments within each asset class in an effort to reduce the risk associated with each individual investment. By holding a significant number of not-too-similar investments, the impact resulting from a negative investment-specific event may be minimized. It is important to understand that the process of diversification entails investing in a significant number of not-too-similar investments with similar risk-and-return trade-off profiles. In doing so, your risk-and-return tradeoff profile will remain constant. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
Cornerstone Principle 9: Optimal Asset Mix
Asset mix refers to both the asset classes and asset subclasses that a portfolio is allocated to and their respective weightings within that portfolio. It is essential to allocate a portfolio's assets in a deliberate and calculated way in order to develop the desired risk-and-return trade-off profile. Thus, allocating assets to those asset classes and asset subclasses to develop the desired risk-and-return trade-off profile defines the optimal asset mix.
Incorrectly allocating assets will create a situation where the portfolio either assumes more risk than appropriate or does not assume enough risk, thereby depriving you of better return potential. As you know, your work does not stop once your portfolio is designed and built. Constant monitoring and rebalancing will need to take place.
Cornerstone Principle 10: Reoptimization
Over time, a portfolio's asset mix, including the resulting risk-and-return trade-off profile, will change due to price fluctuations, with some fluctuations being quite large. To address this issue, reoptimization may be appropriate and needed. Reoptimization is comprised of four different, but somewhat similar, tasks. Think of these tasks as the Four Rs of Reoptimization: reevaluating, rebalancing, relocating, and reallocating.
- Reevaluating is the task of examining recent changes in your life and evaluating them within the context of your portfolio.
- Rebalancing is the task of selling and buying investments in order to return a portfolio's current asset class mix to the previously established optimal asset mix. Tax implications should be considered when implementing a rebalancing strategy.
- Relocating is the task of exchanging certain assets for other assets without changing the overall asset mix or risk-and-return trade-off profile.
- Reallocating is the task of adjusting to which investments your contributions go and in what amount. In this context, reallocating does not change the mix of your assets, only how contributions will be made in the future.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Your situation will vary.
Excerpted from Understanding Asset Allocation by Scott Frush. Copyright © 2007 by The McGraw-Hill Companies.
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