Asset allocation is a broad strategy that determines the mix of assets to hold in a portfolio for an optimal risk-return balance based on an investor's risk profile and investment objectives. Security selection is the process of identifying individual securities within a certain asset class that will make up the portfolio. Both are key components of an investment strategy, but they require separate and distinct methodologies.
It is well established that different types of assets tend to behave differently in response to market conditions. For example, in market conditions when stocks perform well, bonds tend to perform poorly, or when large-cap stocks outperform the market, small-cap stocks may underperform. In investment terms, these assets are not correlated. Asset allocation is the practice of mixing non-correlating assets together to find an optimal balance of risk and return based on an investor’s investment profile. Asset allocation seeks to minimize portfolio risk while maximizing returns for an efficient portfolio.
For an investor who seeks higher returns with the willingness to assume more risk, the asset allocation is weighted more toward equities than bonds. An 80/20 or 90/10 mix of equities to bonds would be considered an aggressive allocation. Within the equity portion of the portfolio, the asset allocation can be further divided among aggressive growth stocks, emerging markets, small-cap, mid-cap, and large-cap stocks. A more conservative investor might choose a 60/40 or 50/50 mix of equities to bonds, with a larger allocation toward large-cap stocks.
After the asset allocation strategy has been developed, securities must be selected to construct the portfolio and populate the allocation targets according to the strategy. Most investors typically choose from the universe of mutual funds, index funds, and exchange-traded funds by matching the funds' investment objectives to the various components of their asset allocation strategy. For example, a conservative investor may look toward funds that seek capital preservation in addition to capital appreciation, while a more aggressive investor may consider funds that strictly seek capital appreciation.
Passive investors tend to focus on low-cost index funds that attempt to replicate the composition of a stock index. A conservative investor might consider index funds that follow the Standard & Poor’s 500 (S&P 500) index or an index of dividend-paying stocks, while a moderate investor might mix an S&P 500 index fund with a smaller allocation in a mid-cap or small-cap fund.
Active investors, who seek opportunities to outperform the indexes, can choose from among thousands of actively managed funds. Larger investors, with more than $1 million of assets, might choose to work with a money manager who selects individual stocks to construct a portfolio.
Which is More Important to Investors?
Asset allocation assumes uncertainty about the future direction of asset prices and that, depending on market and economic conditions at any given time, some assets will increase and others will decrease in value. Asset allocation is more about managing risk and volatility than it is about managing performance. Selecting individual securities assumes knowledge about the future and that the investor has some information that informs him or her about the future direction of prices.
The “Efficient Market Hypothesis” developed by William Sharp showed that stock prices fully reflect all available information and expectations, which would preclude investors from consistently exploiting mispriced stocks. He concluded that investors are better off choosing an appropriate asset allocation and investing in a well-diversified portfolio of passively managed funds. While both asset allocation and selecting appropriate securities is important to an investment strategy, it is more important to target the right asset allocation, which can then be populated with index-tracking funds.