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Asset allocation and diversification are both an art and science. Getting it right goes a long way toward insuring success with your portfolio. The following are the necessary considerations for developing effective asset allocation and diversification in your portfolio.
Asset allocation refers to how a portfolio is divided among the numerous types, or classes of assets that are available to invest in. Among numerous available asset classes are U.S. stocks, bonds, cash equivalents or cash, foreign investments and alternatives. Careful selection of the asset classes that comprise a portfolio as well as the individual investments within each asset class is important to the ultimate performance of the portfolio. While there is some debate over the exact percentage of portfolio performance that should be attributed to asset allocation, there is general agreement among investment professionals that asset allocation is an important determinant of portfolio performance.
Because asset allocation plays an important role in determining portfolio results, emphasis should be placed on allocating the appropriate classes of assets (e.g., U.S. stocks, bonds, foreign investments, alternatives) to a portfolio. Only after determining the classes of assets you will invest in based on your particular objective and the proper proportions of each asset class for your portfolio, should you begin to analyze which individual investments (e.g., mutual funds, stocks, bonds) you will invest in.
Risk is related to asset allocation and risk is inversely related to return. The higher the risk, the greater the potential for a higher return and conversely the greater potential for loss. Investors expect to be rewarded with higher returns in exchange for accepting greater risk and accept lower returns in exchange for lower risk. A major goal of designing and managing an investment portfolio is to maximize total return while keeping overall risk to an acceptable level.
Risk can be measured in a number of ways. One measure of risk for an investment, known as the standard deviation, is how much an investment’s price varies from its mean (average) return over time. It is a mathematical way of expressing price volatility. The greater the standard deviation of an asset, the higher its highs and the lower its lows will be from its mean return. When considering two securities with the same expected return, a rational choice would be to buy the one with the lower standard deviation, because it carries less risk.
The Sharpe ratio is a way of considering the risk of an investment when compared to its return. This is calculated by subtracting the best risk-free return currently available in the market (such as the yield on Treasury securities) from the average return of the investment, then dividing the result by the investment’s standard deviation. The Sharpe ratio is a way of quickly comparing the risk associated with an asset with its historical return. The higher the resulting ratio, the better the risk-reward profile of the investment.
Different classes of investments offer a variety of risk and return combinations. For instance, Treasury securities are considered extremely low risk because they are backed by the full faith and credit of the U.S. government and historically investors who have held them until maturity, have always received the anticipated return on their investment. Small cap stocks by comparison, are considered extremely risky because their performance has historically deviated substantially from their mean (average) historical return. Remember though, that past performance of an investment is no guarantee of its future performance.
Combining different asset classes within a portfolio is called diversification. The goal of diversification is not simply to have many different investments, but to combine complementary investments so that the resulting portfolio will perform well during the investor’s time horizon. To accomplish this, it helps to understand the concept of correlation. Correlation measures the similarity of different investments price movements over time. When the prices of two different investments move identically, they are said to have a correlation of 1.0. When the prices move in exactly opposite directions, their correlation is -1.0. A correlation of 0 means that price movements are unrelated to each other, so that a price movement of one investment is not useful in predicting the price movement of the other.
A well-diversified portfolio consists of asset classes that are not closely correlated to each other. For instance, say a portfolio consists of stocks in U.S. companies in the Large Cap, Mid Cap, and Small Cap categories. This portfolio is not well diversified, because historically all classes of U.S. stocks have tended to be closely correlated. The addition of less highly correlated asset classes such as foreign investments, bonds, and real estate would add significantly to the diversification of this portfolio.
The efficient frontier is a concept from modern portfolio theory (a body of study on markets developed since 1952) that examines the relationship between risk and return for various investment portfolios. The efficient frontier can be expressed as a curved line on a graph. The graph plots risk, expressed as standard deviation, on the horizontal axis and return on the vertical axis.
The efficient frontier line is comprised of the points on the graph that represent where risk is minimized for a given rate of return and where return is maximized for a given degree of risk. In other words, portfolios that fall along the efficient frontier are said to be optimized (known as mean variance optimization). Portfolios that are well diversified among various asset classes will generally perform better over time, approaching or falling along the efficient frontier, than portfolios that are assembled without the benefit of a diversified asset allocation approach.
If you have questions about the above or any retirement-related planning give us a call.
Jeff Christian CFP, CRPC
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