Investment Process

8: Asset Allocation

Asset Allocation is defined by the phrase “Don’t put all your eggs in one basket” is another way of saying that no one should risk all of their resources on any single idea, venture, or asset. Put simply, if all your eggs are in one basket, and the basket breaks or spills, then you’ll lose all your eggs.

Asset Allocation refers to the overall mixture of cash, bonds, bonds, and other asset classes in a portfolio, and how much of the total capital is invested in each one. Having the right balance – the correct asset allocation – is what keeps the portfolio diversified in the market, rather than heavily invested in one thing that could fall down and take the whole portfolio with it.

In investing, asset allocation (or the overall composition of the portfolio) is more important than any individual asset within it. That’s because while a group of assets runs hot and cold, the correct asset allocation keeps the portfolio steered in the right direction for the long-term. Countless investors have lost money by assuming today’s hot group of assets would power their portfolios forever. But it never happens. Invariably, the following year (or even the following month) is dominated by another group of assets. Conversely, investors who maintain an age-appropriate asset allocation tend to win over the long-term because poor individual assets are outweighed by the correct overall mixture. In other words, the system is greater than the sum of its parts. Asset allocation works because it keeps the portfolio diversified and ensures the assets that are not directly correlated with one another.

In a 1991 study, Gary P. Brinson, Brian D. Singer, and Gilbert L Beebower determined that replacing active choices with simple asset classes worked just as well as, if not even better than professional managers.

Bekkers, Doeswijk, and Lam (2009) investigate the diversification benefits for a portfolio by distinguishing ten different investment categories simultaneously in a mean-variance analysis as well as a market portfolio approach. The results suggest that real estate, commodities, and high yield add the most value to the traditional asset mix of stocks, bonds, and cash.

Doeswijk, Lam, and Swinkels (2014) argue that the portfolio of the average investor contains important information for strategic asset allocation purposes. This portfolio shows the relative value of all assets according to the market crowd, which one could interpret as a benchmark or the optimal portfolio for the average investor. The authors determine the market values of equities, private equity, real estate, high yield bonds, emerging debt, non-government bonds, government bonds, inflation-linked bonds, commodities, and hedge funds.

Doeswijk, Lam, and Swinkels (2019) show that a global market portfolio realizes a compounded real return of 4.45% per year with a standard deviation of 11.2% from 1960 until 2017. In the inflationary period from 1960 to 1979, the compounded real return of the global market portfolio is 3.24% per year, while this is 6.01% per year in the disinflationary period from 1980 to 2017. The average return during recessions was -1.96% per year, versus 7.72% per year during expansions. The reward for the average investor over the period 1960 to 2017 is a compounded return of 3.39% points above the risk-less rate earned by savers.

Thirty years have passed since Gary P. Brinson, CFA, Randolph Hood, and Gilbert L. Beebower shook the foundation of the financial investing world by publishing “Determinants of Portfolio Performance” in which they asserted that the variation of asset allocation in a portfolio was responsible for 93.6% of its return, diminishing factors such as stock selection and market timing to a meager 6.4%. Despite that landmark finding, and its subsequent ability to withstand future challenges from skeptics, the prowess of asset allocation continues to be challenged by the decades-old notion that the only way to truly succeed in financial investing is through the “buy-and-hold” strategy that continues to be the mantra of many investors. Thirty years after, and despite all the investors that moved away from buy-and-hold and towards asset allocation, this investment process needs to evolve along with the ever-changing economic landscape. Asset allocation, by itself, cannot give anything better than mediocre rates of return, as the markets are constantly changing, with consistency truly a thing of the past. Risk-adjusted asset allocation, is the optimal investment strategy capable of handling these rapid-fire changes in economic conditions, keeping the portfolio position to build portfolio wealth, be as flexible as the environment calls for, and be able to rotate or exit portions without taking excessive and uncontrollable risks.

We analyzed 5 groups of investible assets – cash, bonds, equities, commodities, and other assets – with 10 different portfolios, passive and active, with different market exposure according to their risk profile. We found the following different market exposition by risk profile:

Also, we found the following different asset allocation portfolios and their market exposures:

2 thoughts on “8: Asset Allocation

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