Imagine for a moment that you have only one investment portfolio: you don't have money in a retirement fund, a college fund, a 401(k), a variable annuity, municipal bonds with one broker and some stocks and mutual funds with another. No, you merely have a single portfolio to meet all of your investment needs - simple, concise and efficient.
In reality, of course, you do have one investment portfolio - you just probably have it divided across a number of different structures. In the aggregate, it forms one portfolio with its own particular investment characteristics. Unfortunately, you probably have little awareness of its characteristics. The multitude of separate entities has caused you to lose sight of the forest for the trees.
If you did have just one investment account though, how would you structure it? What are the critical factors that determine how that portfolio should perform? Let's take a look at what you would choose and show you how to transfer those preferences to your overall portfolio.
Asset Allocation Is the Key
By now you may have heard the mantra that "asset allocation is the key" so often that it barely registers with you anymore.
The belief has its origins in a study by Brinson, Hood and Beebower entitled "Determinants of Portfolio Performance" (Financial Analysts Journal, July/August Issue, 1986). The study concluded that 93.6% of the variation of returns in a diversified portfolio is explained by the asset allocation policy. The key term here is "diversified," but we will address that in a moment.
Your asset allocation decision is critical. Get it "right" and you have accomplished nearly 100% of your task in one step. Even if you have a multitude of accounts at the moment, in the aggregate, you have an overall asset allocation and it is controlling most of your investment outcome.
There are many asset classes, including cash, bonds, stocks, real estate, commodities, precious metals and foreign stocks. Over time, each class has demonstrated certain return and volatility characteristics. You can combine these asset classes in infinite ways to produce infinite risk/return portfolio profiles. Your greatest challenge is to learn why these asset classes tend to behave the way they do and what influences their performance profile. You may know that stocks have shown a tendency to produce greater average annual returns over time than bonds and you may know that stocks tend to be more volatile than bonds, but do you know why that is? If you prefer to save yourself the time of understanding the causes, you can take an "it is what it is" approach and just use past performance tendencies as your guide to structuring your asset allocation policy going forward.
How to Start Allocating
How do you know which asset classes to use? A general rule is that if you don't understand the asset class, don't use it. Don't worry about finding the perfect asset allocation mix. There is no perfect mix - except in hindsight, and even then it changes with each passing moment. A good, suitable mix is all you need to get the job done.
Setting an asset allocation policy is not limited to how the asset classes tend to behave. It is also based on how you tend to behave. Your own return goals as well as your own ability to tolerate volatility and uncertainty make up the flip side of the asset allocation "coin." You must attempt to construct an allocation that has the best apparent ability to match your investment temperament. A sure-fire way to sabotage your long-term investment success is by making adjustments that are helter-skelter of your asset allocation mix based on emotion. If you are going to make tactical changes in allocation along the way, you had better have some rational method to guide you.
While every individual theoretically has a particular investment psyche, one idea is universal: if you are a rational investor, you want to maximize return and minimize volatility. There is no reason to take on more risk if you are not going to get paid for it through the opportunity for greater returns; similarly, there is no need to seek greater returns than you "need."
Jackie Stewart, "The Flying Scot," won three world drivers' championships in Formula 1 racing during his eight-year career. He told an interviewer once that his goal in each and every race was to win that race at the slowest possible speed. The interviewer was confused. What did he mean? Stewart explained that it made no sense to him to risk a wreck or mechanical failure by pushing the car any faster than he needed to in order to finish first. Whether he won by a meter or a mile, it did not matter - it was still a win. Jackie Stewart was notorious for his smooth and effective driving style. Now you know the mindset that guided him in taking that smooth approach. You should have a similar mindset in setting your portfolio. Choose the asset allocation that has the greatest chance of allowing you to reach your goal with the least volatility along the way. If you can reach your goal with an 8% average annual return, don't risk "crashing" by attempting to get 10%.
Systematic Vs. Unsystematic Risk
The Brinson, Hood and Beebower study dealt with diversified portfolios. If you want to capture the performance characteristics of United States domestic stocks, you aren't going to do it by only owning the stock of one company. The reason has to do with systematic and unsystematic risk.
Systematic risk is the risk inherent to the entire asset class. Broad economic and political conditions are going to impact the earning prospects of all companies, which in turn will impact the price of their stock. Different companies, and thus their stocks, will have varying degrees of sensitivity to these broad influences, but all will be impacted and there is little you can do to avoid it.
Unsystematic risk is specific risk that is inherent in each individual holding. If a promising new blockbuster drug being developed by a pharmaceutical company suddenly proves worthless, it will have a materially negative effect on that company's stock value, but little to no effect on other stocks. Studies have demonstrated that unsystematic stock risk can be diversified away by holding only 20 to 30 stocks that are not highly correlated in terms of specific industries. (In other words, holding 20 utility stocks still exposes an investor to unsystematic risk associated with the utilities industry, so your industry exposure must be more diverse.) Proper diversification works because negative events for one holding are typically offset by positive events for another holding. Return is supposed to be the price you are paid to assume risk, so it makes no sense to expect incremental return from the unsystematic component of a stock's risk profile, because that component can be so easily diversified away.
What cannot be diversified away is systematic risk and stocks have a different level of systematic risk than bonds, cash, real estate, etc. Over time, the return prospects of the asset class are therefore a function of its systematic risk profile.
To capture the performance of a given asset class you must have a broad, diversified exposure to that asset class. Again, depending on the asset class, this may be effectively accomplished through some number of individual holdings or it can be accomplished by owning an index fund, exchange-traded fund, mutual fund or any other broadly diversified asset class portfolio.
The Bottom Line
If asset allocation takes care of nearly 94% of your portfolio's investment profile, what influences the rest? The answer is individual security selection and market timing. The things that come to mind for most people when you mention investing are only incremental factors in determining a diversified portfolio's performance over time - but they are focusing on the 6% and missing the 94%!
If you already have multiple investment accounts, think of your portfolio as one investment and analyze the composition of that investment to determine your current asset allocation. Make certain this allocation is appropriate for your goals and investment temperament. Confirm that you are exposed to all areas of the asset class in order to minimize unsystematic risk. If you are creating a new portfolio, start with the asset allocation and structure your investments in a way that gives you broadly diversified exposure to each asset class. After that, relax, because everything else is merely incremental.
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