Does Asset Allocation Always Work?
Ron DeLegge, Editor
September 22, 2009
SAN DIEGO (ETFguide.com) – The concept of asset allocation is a cornerstone of portfolio construction and management. And while it may sound complicated, the general idea is very simple.
Asset allocation begins with an unobstructed view of the entire asset class universe. Examples of important assets include cash, commodities (NYSEArca: GCC), corporate bonds (NYSEArca: LQD), gold (NYSEArca: GLD), real estate (NYSEArca: VNQ), international stocks (NYSEArca: EFA) and U.S. stocks (NYSEArca: VTI). Which of these areas should you own?
Deciding which assets to include or exclude from your investments is a personal decision. Still, it should be a decision not left up to accident or chance.
Let’s evaluate asset allocation techniques used by many investors.
Asset Allocation with Stocks and Bonds
Some investors choose to build their portfolios one brick at a time. Bond investors, for instance, may choose to ladder their individual bond holdings by maturity or by credit quality. Along similar lines, stock investors may decide to own individual stocks they feel are appropriate representatives of specific asset types. For example, owning Simon Property Group (NYSE: SPG) could be viewed as the commercial real estate portion of one’s investments.
While building your portfolio’s asset allocation one security at a time gives you control, it has drawbacks. What if the individual stocks and bonds you select blow up? Also, obtaining broad asset class exposure using individual securities can be time consuming and expensive.
Asset Allocation with Mutual Funds
Mutual funds have become popular asset allocation tools as the $10 trillion or so invested in them illustrates. An accurate asset allocation plan, however, is often complicated by fund managers that deviate from the fund’s stated goals, which creates an unwanted situation known as “style drift.”
A text book example of style drift is the FPA Capital Fund (Nasdaq: FPPTX), which is categorized by Morningstar as a mid-cap value fund. Instead of broadly representing midcap value stocks as an asset class, FPPTX has huge sector bets on energy and consumer services stocks that could come back to bite shareholders. Even more worrisome is the fund’s almost 25% position in low-yielding cash. Who in their right mind would ever buy a mid-cap value fund for outsized exposure to cash?
Behavioral Aspects to Consider
Humans, much like animals, often find safety in numbers. Whatever the majority does must be correct, right? But, what if most investors are heading for a cliff? In this regard, asset bubbles often complicate and tempt a person’s attention to diligence and prudence.
Before the meltdown in residential real estate, more people than ever were allocating a greater portion of their financial resources into homes, condominiums and apartments. They saw property values rising quickly and they couldn’t get enough. As a result, real estate became an unusually larger part of their investments. Their asset allocation got out of whack and it came back to haunt them.
A detailed analysis of investor sentiment shows that the market is usually ready to collapse when investors get too confident about the future outlook. An examination of this phenomenon was recently covered in “The Herding Effect and Why Investors are Usually Wrong.”
Does asset allocation always work? While the concept is still a time tested strategy, its effectiveness is frequently diminished by its mis-application. Using the wrong types of investments along with poor behavioral decisions hurt too. And even if you get it right, asset allocation still won’t necessarily prevent occasional blow ups from happening. The financial markets are always full of surprises.
In summary, always strive to obtain an asset allocation that you’re comfortable with and one that matches your investment goals. Don’t forget to regularly rebalance your portfolio back to your original or intended asset mix. Leave nothing to chance and always be deliberate with the financial decisions you make.