How To Select A Financial Advisor: The Least You Should Know (Part 12 In eBook Series)

How To Select A Financial Advisor: The Least You Should Know (Part 12 In eBook Series)

Chapter 11:The Importance of Proper Asset Allocation

The way in which you allocate your assets among asset classes, such as stocks, bonds, and cash will have the greatest impact on your investment results. Studies show that up to 88 percent of the variation in returns is explained by one’s asset allocation, not by individual security selection, fund selection or market timing.

What Is Asset Allocation?

Asset allocation is the process of combining asset classes such as stocks, bonds, and cash in a portfolio in order to meet your goals.

A financial advisor, whether a retail broker or independent investment advisor, can add value by helping you make the important decision about how to allocate your investment assets. Essentially, asset allocation is the concept of proper diversification—not putting too many eggs in too few baskets, and of seeking the most efficient balance of the perceived risk and expected return.


Take stock of your mood when you determine your asset allocation. If the stock market has been rallying, you may be tempted to over-allocate to stocks. Also, be advised that fees are higher for managing stocks, as opposed to bonds. This creates an incentive for your advisor to recommend greater exposure to stocks.

Asset allocation is a deliberate strategy that is designed to minimize the correlation between asset classes, such as stocks and bonds. This should help reduce your portfolio’s volatility, and help keep you invested during trying market conditions— the key to investment success over the long haul. Consider the following illustration depicting the impact to risk and return brought about by various allocation mixtures.

Proper asset allocation is critical to keep pace with inflation. The illustration on the following page offers some historical perspective of stocks, bonds and inflation—the relentless and invisible thief of purchasing power.

Asset allocation is an analytical endeavor that your advisor should be trained to do. He should have advanced computer software to help consider several allocations, and should create projections of how those allocations might work in the future. That is your advisor’s job. Most financial services firms offer asset allocation software on their respective websites.

Asset allocation starts with you. You have a responsibility to clearly communicate your objectives and your risk tolerance to your advisor, because they form the baseline for his analysis.

Determining your risk tolerance is critical. When you meet with your financial advisor, or when you complete the risk tolerance section of a questionnaire, take stock of your mood. Are you in a good mood? Has the market been rallying lately? These things can make a difference in how you identify your risk tolerance at any given time. For instance, when the market is in the midst of a significant sell-off, you will probably state that your risk tolerance is lower because you are watching what can happen when the market falls. Without an accurate read on your true risk tolerance, arriving at the best asset allocation targets may be difficult. The target allocations may be too aggressive, or not aggressive enough. Garbage in, garbage out.

Your advisor should also take other factors about your financial situation into account when developing the asset allocation. These include your income, savings and spending patterns, financial goals, insurance coverage (life, disability, long-term care, and property). These factors will affect an advisor’s assessment of both your emotional ability to tolerate investment losses and your actual financial ability to tolerate them.

Once the desired asset allocation is determined, your advisor should create a portfolio with that allocation and rebalance the assets to maintain your allocation target. Whether rebalancing is done quarterly, annually, or whenever one asset class is above or below the desired level by a certain percentage is not as important as the act of rebalancing. Target allocations should be reviewed periodically.

Actual rebalancing is fairly simple mathematics. Let’s assume that your target portfolio allocation is 45 percent stocks, 45 percent bonds, and 10 percent cash. Now, let’s assume that your stocks fall in value to 40 percent of your portfolio, while your bonds rise to 50 percent. It’s time to rebalance. You (or your advisor) would sell 5 percent of the bonds and buy an additional 5 percent of stocks. You are redeploying assets to the asset class that has experienced price weakness. Consider the following illustration comparing portfolios that were rebalanced, versus those that were not.

I liken rebalancing to a pilot keeping the wings of the airplane level.

Whenever rebalancing is needed, be sure that your financial advisor is being tax-wise about harvesting your capital gains. To the extent possible, capital gains should be offset by losses where appropriate to reduce capital gains tax liability.

It’s also important to be balanced within each asset class. Stocks can be divided into several categories, such as value stocks, growth stocks, international stocks, small-company stocks (small-cap), medium-sized company stocks (mid-cap), and large-company stocks (large cap). “Cap” is short for market capitalization. A company’s market capitalization can be determined by
multiplying the number of shares outstanding by the current price of the stock.

Bonds can be divided into various categories as well, such as investment-grade corporate bonds, high-yield (junk) corporate bonds, U.S. government bonds, tax-free municipal bonds, etc.

Modern Portfolio Theory and True Diversification
Diversification among asset classes will determine the amount of overall portfolio volatility you experience. This is why it is so important to have a mixture of asset classes that do not tend to all trade in the same direction at the same time. In other words, you should seek a blend of asset classes that are not highly correlated to each other, or that are negatively correlated.

In 1952, Dr. Harry Markowitz developed a theory around this concept. In 1990, he won a Nobel Prize for developing what is known as Modern Portfolio Theory, reducing overall portfolio risk by blending certain asset classes.

Diversification is not perfect, but being less diversified is certainly not the answer. In a financial panic—like the one in 2008—investors place a premium on liquidity. This can pressure a great many asset classes at once, so that their correlation is high for a period of time. When the panic subsides, more normal correlations return.

Owning several mutual funds does not necessarily mean that you are truly diversified. If the funds own many of the same securities, you have not achieved proper diversification. Also, mutual funds suffer from what is known as style drift. In other words, a fund that is supposed to invest in growth stocks might drift by purchasing value stocks. If you already had value stocks in another fund, you might wake up one day to find out that you are too heavily invested in value, and you have lost exposure to growth-stocks.

Active managers tend to specialize in one type of stock or another, such as value or growth. Growth managers are looking for companies that are growingquickly, and hopefully, growing profits quickly. The stock prices of these companies are volatile, and their share prices can drop quickly if they show signs of losing momentum. Value managers tend to look for slower-moving companies, often companies that are not widely desired. Value managers hope that those companies can turn things around, raise earnings, and thus gain in value.

History suggests that value is superior to growth. However, we have seen periods when the growth style outperformed the value style, or vice-versa. In the following illustration, value stocks significantly outperformed growth, and small-cap stocks of the value style significantly outperformed their large-cap value counterparts; however, that’s not the most important point. The most important thing is to be diversified, no matter what.

Moreover, investors who select a mutual fund that purports to be in a particular category, such as small-cap stocks, might not get what they expect. A small-cap fund might own quite a few mid-cap stocks as company valuations grow over time. Such drift makes it difficult to pinpoint a client’s exposure to a particular asset class at any given time. Keeping up with the changes in your asset allocation caused by drift is a little like herding house cats, especially since most mutual funds report positions with a one-month or one-quarter lag.

Investing in index funds can help solve this problem. At least you know what you own.

In the previous three chapters, I summarized the main arguments in favor of a passive investment strategy based on a carefully designed asset allocation: it will keep costs low and reduce the tendency to invest emotionally. In the next section of the book, I will discuss which investment products can support that strategy, and which should usually be avoided.

“Diversification is the only free lunch in finances.”
`Harry Markowitz, Nobel Memorial Prize In Economics Science

Have a question? Contact Ed Mahaffy.

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