REALITY-BASED ASSET ALLOCATION

There is certainly no lack of opinions when it comes to asset allocation, each espousing a “best” recipe for divvying up our investable dollars among different categories. The concept underlying it all—different types of assets respond in different ways, and at different times, to various market forces. Generally speaking, that advice about not putting all our eggs in one basket—well, let’s just say it’s a lot older than we are, and has stayed around because, in general, it has worked.

Asset allocation is based on Modern Portfolio Theory, which argues that because different asset types are negatively correlated, they balance each other. Any one investment’s performance, therefore, becomes less important than how it impacts the entire portfolio. Since most investors are risk-averse, the theory goes, they are best off investing in multiple asset classes. The consensus is that asset allocation is one of the most important decisions investors make, and, in fact, accounts for nearly half of investment results!

Asset allocation is typically approached with reference to two sets of threes:

  • 3 investor characteristics: risk-tolerance, age, and specific goals
  • 3 asset classes: equities (stocks), fixed-income (bonds), cash and cash equivalents, although other investment types such as real estate and precious metals may also make up part of the asset mix

An old Chinese curse, “May you live in interesting times,” certainly appears to be in effect today. In a Lord Abbett survey of money managers for endowments and foundations, most reported they were “struggling to find the right balance of risk and return in a challenging environment of historically low interest rates and elevated concerns about a market correction.”

In fact, investors seeking the right asset allocation are facing several new realities. 

New realities of risk tolerance:

  • Even investors who’ve prided themselves on remaining calm and reasoned during periods of stock market volatility may have changed their attitude after a job loss or furlough or fear that one might be in store.
  • Entrepreneurs may rethink plans to start new businesses based on fear of virus-dictated shutdowns or of tax changes in a changing political climate.

New realities of fixed income and cash investments:

Fixed income is the term for investments in which the issuer is a borrower who is obligated to make payments of a fixed amount on a fixed schedule, then repay the principal amount at maturity. A bond might be issued by a government entity—federal, state, or municipal—or by a corporation. Bank certificates of deposit (CDs) and savings accounts can also fall into the fixed income category.

  • Today’s yields on fixed income continue to be historically low, with yields on ten-year U.S. Treasury bonds well under 2%, and investors barely breaking even with inflation.
  • There is essentially no differential in yield today between cash and fixed-income investing.

New realities of global stock investing:

One tactic for diversifying the stock portion of a portfolio is by adding international equities to the portfolio along with U.S. company stocks. The concept is that stock markets in other parts of the world rise and fall at different times.

  • Today, the “world is getting smaller” in the sense that correlations between the performance of overseas equities, particularly those of developed countries and domestic stocks, are very high.
  • Many large, U.S.-based companies are multinational, already providing investors with exposure to economic forces outside our borders.

The concept of asset allocation has been a traditional investment model for many decades, and, generally speaking, that advice about not putting all our eggs in one basket has worked. Money management strategies, though, must always be based on reality, and investors would do well to heed the new realities we face in the world of today.

sudarsan

Sudarsan Chakraborty is a professional writer. He contributes to many high-quality blogs. He loves to write on various topics.