Asset Allocation: Myths & Realities
© Sound Mind Investing | December 2012
SMI has often called asset allocation "your most important investing decision." However, it is not a magic bullet that always protects a portfolio from loss, nor does it guarantee market-beating returns. Let's take a closer look at exactly what asset allocation canand can'toffer investors.
WHAT IS ASSET ALLOCATION?
Asset allocation describes the process an investor goes through in dividing his or her money among various types of investments (also called "asset classes"). This typically begins with a decision on how to divide a portfolio between stocks and bonds, but may involve including other broad asset classes, such as gold and real estate, as well. (See a previous article titled The Crucial Role of Diversification in Reducing Risk.) Numerous studies have validated the fact that these asset-allocation decisions determine investment returns much more than the specific investments chosen within each asset class.
Done properly, asset allocation enables an investor to build a portfolio that balances risk and reward, typically based primarily on the investor's age. The younger the investor, the more appropriate it is for the portfolio to be heavily, if not completely, concentrated in stocks and other invest-by-owning kinds of investments. (Learn more in our New Reader Guide PDF download.) While a portfolio consisting primarily of stocks and stock funds will experience significant ups and downs along the way, such an approach has rewarded the long-term investor better than any other asset class. (See a previous article titled Who Needs the Stock Market?) However, as investors age, they have less time to ride out market swings to the downside. So, it's wise to gradually decrease portfolio volatility by reducing stock-based investments and increasing the bond allocation.
WHAT ASSET ALLOCATION CAN'T DO
Perhaps the greatest myth of traditional asset allocation is that it will eliminate losses. Diversifying across different asset classes can decrease the volatility of a portfolio, but there are occasions when almost all asset classes move down together. This was true in 2008; bonds generally made money while everything else plummeted. Still, that year provides a great illustration of how asset allocation impacted how much people lost.
Consider the chart on the right. An investor who was 100% invested in SMI's stock Upgrading strategy lost -38.8% in 2008. Shifting the allocation mix to 40% stocks and 60% bonds limited losses to -12.7%.
Of course, this works both ways. As the market has recovered, the 100% stock investor has enjoyed a much larger rebound than those with more conservative allocations.
TO FIX OR TO FLEX?
The process we've been discussing so far is known as strategic asset allocation. This form is what SMI has long taught: begin with your risk tolerance and season of life, and build a more-or-less permanent asset allocation plan based on those factors.
For strategic asset allocation to work, however, it requires investors to stick with the allocation through good markets as well as bad. Normally, the only changes made to the allocations are to rebalance the portfolio annually in order to bring it back into alignment with the initial allocation schedule.
The problem with strategic asset allocation, of course, is that investors' emotions frequently get the best of them. They may start out with the best of intentions to stick with their long-term allocations "through thick and thin," but eventually the fear caused by steep market losses causes them to shift to a more conservative portfolio (that is, they reduce their stock portion and increase their fixed-income holdings). This usually serves to lock in existing stock losses at an inopportune timewhen the market eventually rallies, their recovery is slowed by their more conservative allocation.
UNDERSTANDING TACTICAL ASSET ALLOCATION
As market declines steepen, emotional stress grows. Experience shows that many investors are going to do something in an effort to relieve their emotional pain at those pressure points. Recognizing this dynamic is what led SMI to create toolsspecifically our Bear Alert and All-Clear Indicatorsto allow investors to respond protectively without sabotaging their long-term results. By letting readers scratch this emotional itch within the confines of a structured, mechanical system, the hope was to avoid having them take more dramatic steps that would ultimately damage their long-term investing returns.
Making allocation changes in response to market events is what's known as tactical asset allocation. Such an approach offers a particular set of strengths and weaknesses just as strategic asset allocation does.
Critics sometimes dismiss tactical asset allocation as "market timing," and depending on the way it is carried out, it can be just that. But there are many different approaches to tactical asset allocation, ranging from making small incremental adjustments to an otherwise unchanging asset allocation (as SMI has done in the past), to making wholesale switches based on various factors.
In next month's cover article, we'll discuss a new advanced strategy built around the concept of tactical asset allocation. It will add a new tool to the SMI strategy toolbox that can complement our existing strategies and potentially strengthen your ability to respond to, and weather, market storms. We believe this ability to play good defense is going to be of increasing importance in the years ahead.
Arriving at the asset allocation that best fits your personal situation, in whatever form it is practiced, is a vital component of investing success. When it comes to investing, emotional decision-making typically leads to poor performance. A personalized asset allocation modelusing an objective, measurable process for dividing your portfolio among diversified asset classesprovides a solid first line of defense against investing-by-emotions.