Asset allocation is a mathematical approach for increasing your investment returns, while minimizing your risk. A mathematical approach is used to estimate the risk and return of an asset class and mathematical models are used to analyze how different asset classes interrelate to one another. Asset allocation is based on risk and return, diversification, asset class correlation and rebalancing. I know it sounds complicated, so let’s take a look at each term individually.
Risk and Return
Investing in any asset class requires taking a risk. The return that is achieved is dependent on the overall risk of the portfolio. Risk is defined as the volatility of the investment. The greater the risk of the portfolio, the greater the expected return for taking on the uncertainty of that investment. Think about it this way, why would you make a risky investment if the rate of return on a risky investment was not greater than that of a non-risky investment? Asset allocation is a method for strategically assembling a portfolio of various asset classes that maximizes return and minimizes risk. The risk and return of a portfolio should be tailored to an individual’s investment needs.
Risk is reduced via asset allocation through diversification. Diversification is the practice of buying numerous asset classes to reduce the chance of sustaining a large loss. If I invest 100% of my portfolio in stocks and the market goes into a severe bear market (such as right now), my portfolio can lose 50%, if not more. However, if I invest half of my portfolio in stocks and half in bonds, even in a bear market, I will lose significantly less. By investing in more than one asset class you can reduce your risk.
Diversification is also important within each asset class. Even if I wanted to invest 100% in stocks, I definitely wouldn’t want to invest everything in one company. Individual stocks can lose 100% of their value. By investing in index funds, you are diversifying your asset class as much as possible, and reduce the risk of losing your entire portfolio.
The benefits of diversification requires that asset classes do not act in the same way. Diversification would not be as effective at reducing risk if every asset class went up or down at the same time. Correlation is a mathematical analysis of the tendency of different asset classes to move in the same direction. A perfectly positive correlation (1.0) occurs when asset classes move in the same direction at the same time. A perfectly negative correlation (-1.0) occurs when asset classes move in opposite directions at the same time. It is most beneficial for diversification purposes to hold asset classes that are negatively correlated in your portfolio.
Holding negatively correlated asset classes in your portfolio reduces risk because you can have one asset class decrease in value and another asset class increase in value at the same time. It is very difficult to find negatively correlated asset classes, or even non-correlated asset classes, but asset classes with a low positive correlation can still provide the same benefits. It is important to know that asset class correlations are not consistent. Asset classes can have negative correlations for a period of time and then have a period of high positive correlation. When assembling an asset allocation strategy, it is prudent to use a correlation value that is averaged over a long period of time.
So far everything discussed has been all about reducing risk, however, correlation is also essential for increasing the return of your portfolio via rebalancing. The fact that asset classes have varying levels of correlation means that any given asset class has the potential to provide the highest rate of return for any given year. Ideally, you would just invest 100% in the asset class that will provide the highest rate of return. Unfortunately, nobody knows which asset class will provide the highest rate of return in advance. This is where rebalancing comes in.
Everybody has heard about selling high and buying low. Wouldn’t it be great if you knew when stocks are at a peak during bull markets and at a valley during bear markets? Because we can’t predict the future, we have to force ourselves to buy low and sell high. A well diversified portfolio will have some asset classes that will outperform others, which will cause a shift away from your desired asset allocation. Rebalancing is the act of selling assets that have performed well (selling high) in order to buy more of the underperforming assets (buy low) to regain your desired asset allocation.
Rebalancing a well diversified portfolio consisting of asset classes with a low correlation will deliver slightly higher returns. Asset allocation combines different asset classes that each have unique risk and return characteristics, into a portfolio that has a unique risk and return, which is tailored to each individual’s investment plan. A portfolio designed using the asset allocation principals outlined above will have a higher return and a lower risk than each of the individual asset classes of the portfolio.
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