Asset Allocation

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Asset Allocation

Jul 31, 2012 | ASSET MANAGEMENT

“Don’t put all your eggs in one basket”

The goal of the portfolio manager is to balance risk and return. The art and science of asset management is to achieve the highest possible return with the lowest possible risk. Modern Portfolio Theory, as advanced by Harry Markowitz in 1952, teaches that portfolios should be constructed not by selecting individual perceived to be good investments, but by selecting investments that diversify the portfolio to maximum return and minimize risk.

Model Portfolio Theory teaches that asset classes tend to move in different directions. Portfolio managers call this “correlation”. Assets can be positively correlated, meaning they move in the same direction, negatively correlated, meaning they move in opposite directions, and uncorrelated, meaning they move independently of each other. The generally accepted asset classes are: equity or stocks, debt or bond, commodities, real estate, and cash. There are a wide range of subcategories, that will not be discussed in this article. To give an example of correlation, stocks and bonds used to move in mostly opposite direction, and real estate moved independently of stocks, but was influenced by the movement of bonds. Also, within the asset classes there were varying correlations. International stocks used to move in a different direction from US stocks, and small company stocks had a different cycle from large company stocks. To balance risk and return, portfolio managers overweight the assets they think will outperform and underweight the assets they think will underperform. You would only rarely exclude an asset class. After all, anything might happen to change the investment landscape. However, in time, balancing risk and reward turned into allocating assets in a manner that the investments would effectively offset each other. In other words, portfolios were constructed to ensure that each investment had a negatively correlated counter-investment. Another practice that became standardized was the model portfolio. Model portfolios were constructed based on age and risk tolerance. Economic factors were ignored and financial analysis became secondary. With globalization and increased securitization, these model portfolios did not balance risk and return. Asset classes are more positively correlated with few options for uncorrelated or negatively correlated investments. That said, model portfolios are an extremely useful tool and diversification is still the goal. But, age and risk tolerance is a small part of the formula. Diversification is still critical to long-term investment success. With patience, research, and analysis a diversified portfolio can be constructed.

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