The simplest definition I can give is; asset allocation is how your assets are divided among different asset classes.
Asset classes include investments such as stocks, bonds, cash, real estate, etc.
During my client conversations I frequently get the following questions:
- Why are three or four investments doing so badly?
- Why do we own these?
- Why not buy more of the three or four investments that are doing well?
Really Pay Attention to This Part
If I’ve properly structured a portfolio to utilize asset allocation, then there will always be there or four positions that seem to be stinkers (the ones you scratch your head about). There will also be three or four investments that will seem to be superstars (the ones you love to own). The remaining investments will fall somewhere in the middle.
Remember I said pay close attention? Todays superstars are tomorrows stinkers and vice versa. You never know which investment will take the lead next. A few great performers, a few stinkers, and a few in the middle. That will never change.
The challenge is that we never know which investments are going to be the leaders at what time. Yes we know that small caps probably will do better at the beginning of an economic cycle, and that bonds will do poorly in a rising interest rate environment.
What if you’re wrong? It’s a safer bet to spread the risk across many asset classes and sub asset classes.
To make my point, take a look at the Callan Chart below (click to enlarge). The top row is the best performing asset class that year, and the bottom row is the worst. You can see that the winners and the losers rarely repeat themselves. Therefore, making it extremely difficult to predict which of the three or four investments to keep.
In addition, the standard diversified portfolio (Standard DP) fluctuated less and had more consistent returns. Plus, the 20 year annualized performance numbers were pretty good.
Diversification with asset allocation is a great tool to control risk. If you’re not sure you have an asset allocation that is working, feel free to give me a call at 859-225-2596. Want to learn more? Subscribe and get my articles for free every Friday delivered to your inbox!
Source: Lipper, Inc. and Morningstar. Performance information represents past performance and does not guarantee future results. The information provided is for illustrative purposes only and is not meant to represent
the performance of any particular investment. Investing involves risk. Asset class returns are represented by the returns of indices and/or Lipper mutual fund averages and are ranked on an annual total return basis. It is not possible to invest directly in an index. Performance results assume reinvestment of distributions.