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Asset Allocation:
The Real Secret of Diversification

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Asset allocation sounds intimidating, but it's really nothing more than the old saying "don't put all your eggs in one basket".

As Barry Ritholtz says on his blog, The Big Picture, "Stock picking is for fun. Asset allocation is for making money over the long haul."

If you want proof, take a look at stock market returns in 2008 in the chart below. You would have had better returns putting your money in a savings account!

Color table showing asset class returns from 2004-2013
Performance of different Asset Classes from 2004-2013
Click on the image to enlarge

[Source:Guggenheim Investments]

Everyone that tried to find the world's best stock probably ended up losing money. Bonds performed well...nothing too exciting.

Fast forward to 2009...cash had the lowest, positive return while stocks exploded higher. You could have picked stocks by throwing darts at the business section and everyone would have complimented you on your stock picking prowess.

Asset allocation isn’t about picking stocks or being in cash per se; it’s how and when you allocate money between the two (or any other asset class).

What is Asset Allocation?

When done correctly, your money is spread across several different types of assets, so that the returns of one asset class don't make or break your personal finances.

This means that your portfolio’s level of "diversification" is actually the result or outcome of asset allocation. If you want diversified investments, you need to use proper asset allocation.

You can break it down into two parts:

  • Strategic: The different ways you can do it
  • Tactical: How you actually use those ways to do it

Why is Asset Allocation Important?

Prices are dynamic and you can't predict which way they'll go in the future. You might get the price right, but the timing wrong. Or you might get the timing right for a change, but be way off in the magnitude.

The same issue applies to long term investing; you cannot predict which allocation strategy will provide the best returns, because the investing environment is constantly changing. Shifts in macroeconomic, microeconomic, geopolitical, technological, social, and even regulatory factors can influence each asset class differently.

In order to achieve true diversification, you'll not only need a mix of asset classes, but also a mix different investing strategies. For example:

  1. Within an asset class (least diversified)
  2. Across asset classes
  3. Across strategies
  4. By selection technique (most diversified)

1) Within an Asset Class

For real assets, you can change the expected returns by varying the type of investment you choose:

  • Type of Asset (Real Estate, Commodities, etc.)
  • Type of Instrument (Physical, Fund, Trust, Contract)

For equities, you can change expected returns by varying:

  • Capitalization (Small, Mid, Large)
  • "Growth" vs. "Value"
  • Sector (Healthcare, Technology, Utilities)
  • Industry (Automotive, Mining, Tech, Oil/Gas)

If you decide to buy and hold an index ETF, or a even a bunch of different stocks, you still only 1 asset class (equities) and are only getting a small amount of diversification.

For debt instruments, you can change the expected returns by varying:

  • Type (Personal, Corporate)
  • Duration (1,3,5,10 year)
  • Rating (A, AA, B, Junk)

2) Across asset classes

Traditionally, investments are grouped into four categories called asset classes. Stocks (equities) and bonds (fixed income) are the two most commonly known, with real estate and insurance coming in third and fourth respectively.

Individual investors now have access to asset classes that were historically used by wealthy investors, due to the availability of financially engineered products (such as ETFs). These “new” classes include currencies, commodities, leveraged funds, etc.

More recently, certain strategies have even been classified as an “asset class”, such as managed futures.

3) Across Investing Strategies

4) Across Investing Techniques

Practical Asset Allocation

Choosing between strategies takes time! It's why so few people do it.