Old School Rules: Diversify Through Asset Allocation 

How Asset Allocation Naturally Balances Your Portfolio for a Long-term, Smooth Ride 

John Schloegel

Proponents of diversification usually speak in terms of 'asset allocation'.  Asset Allocation refers to a systematic way investors place investments in their portfolio, all in an effort to meet some sort of objective.  The aggressive investor may have 80% of their investments in stocks, and the other 20% in cash or bonds.  However, a conservative investor may flip that equation, placing 80% of their assets into bonds and cash and the other 20% in stocks.  The asset classes you choose will depend upon your time frame, and more likely, your ability to handle volatility.  Mind you, the key points many miss when determining asset allocation and goal setting is taxes, inflation, and currency changes.   Our analysis of the capital markets suggests investors do not obtain the required rate of return necessary to beat the effects of taxes, inflation, and currency changes when they invest predominantly in fixed income.  We typically advise investors to hold equity portfolios and reduce their dependence on fixed income securities. 

Stocks, Bonds, & Cash:

Stocks:  Stocks have historically earned higher returns than all other asset classes.  In addition, stocks have also performed better than real estate, coins, rare art, and a host of other alternative assets that some people invest in.  The key point, is stocks have out-performed inflation (the rising cost of goods, services, food, energy, and the cost of living).  Equities fluctuate in value, and carry the risk that your investment can decrease in value, and decrease in value suddenly and without warning at any time.

Bonds:  Bonds do not fluctuate as much as stocks and therefore have lower market risk.  As their long-term rate of return is not as high as stocks, they also perform poorly against inflation. 

Cash/Money Market:  Typically a stable asset class, money market funds and cash carry low risk and low returns.  This asset class lacks the potential to beat inflation over time as compared to stocks.

Diversification:  When you "diversify" your investments away from a single security, you reduce your "individual security risk."  The single security risk is the fact that your one investment will fluctuate in value and your portfolio is dependent upon a single entity.  That could make for a wild ride indeed.  Diversifying among two or more securities, or asset classes may increase the chance that when the return of one investment is falling, the return of the other investment may be rising.

The key to diversification or asset allocation is that it should change over time.  A pithy way to explore this topic is to say:  "You concentrate to get rich, and you diversify to stay rich."  Bill Gates is one of the richest Americans due to the fact that he made his fortune holding one stock.  The same is true of the Walton's and their success in Wal-Mart shares.   However, Bill Gates has a systematic divestiture plan, selling Microsoft shares every quarter in order to diversify.  Also, many investors change their allocations as their age changes.  A twenty year old will probably invest much differently than a seventy year old. 

How important is Asset Allocation?

Famous studies have pegged the asset allocation decision as determining 80% or 90% of your portfolio return.  That means how much you allocate to stocks, bonds, or cash is the paramount decision.  The other elements of your portfolio return will consist of the types of stocks, bonds, or cash you choose, and finally, in least importance, what individual security you ultimately own. 

The asset allocation that is right for you depends on your time frame, goals, and tolerance for risk.  As your time frame and goals change, your allocation will change.  We find that most investors forget the impact of taxes, inflation, and currency on their net worth, and it is recommended investors emphasize equities if they are comfortable with that approach.