As we flip the calendar and enter 2024, many people create New Year’s Resolutions, largely designed to improve an aspect of their lives. Many of these goals are exercise, diet, or financial based. One area we always encourage people to review at the start of each year is their investment portfolio, the risk associated with the underlying investments, and whether the portfolio is still designed to people’s needs, goals, and current stage of life. As we all know, life goes by fast, so staying on top of investments is an important part of being financially disciplined.
With recent market volatility renewing anxiety for many investors, it is a stern reminder of the value of having a proper mix of assets in your portfolio. The concepts of asset allocation and diversification can be traced back to a 4th-century text, the Babylonian Talmud, which said, “One should always divide his wealth into three parts: a third in land, a third in merchandise, and a third ready to hand.” While this may have been sound advice at the time, many of today’s asset allocation decisions are based on a doctoral thesis written by a University of Chicago economics student in 1952.
The essay titled “Portfolio Selection” was written by Harry Markowitz and is considered, by many, the Holy Grail of investing. In his thesis, Markowitz introduces Modern Portfolio Theory, the idea of an optimal “efficient frontier” where a set of portfolios provides a maximum return for a given level of risk. In theory, these “optimal” portfolios are created by diversifying investments across a broad range of asset classes whose returns are not correlated, therefore reducing overall volatility.
Asset allocation in its most basic form is the practice of dividing investments between stocks, bonds, real estate, cash, etc. Although it sounds quite simple, deciding on the right allocation is vital in controlling how risky your portfolio is, and it should be well thought out. A 2000 research paper written by Roger Ibotson and Paul Kaplan states that asset allocation is responsible for 90% of portfolio returns. Although this study was meant more for institutional investors than individuals, the fact remains that choosing the right allocation is critical, and likely even more important than selecting specific investments. Here are a few items we consider when helping our clients establish the appropriate allocation:
- Defining Clear and Realistic Investment Goals
- Time Horizon for Investing
- Liquidity/Income Needs
- Tolerance for Risk
- Global Household Allocation
Another important aspect of asset allocation is that it helps investors keep a long-term perspective to avoid making decisions based on emotion. Investors tend to chase performance by abandoning poor-performing sectors in search of greener pastures. This attempt at market timing has led to very poor long-term performance for the average investor (see graph below).
Source: Dalbar, Inc., 30 years from 1991-2020; “Quantitative Analysis of Investor Behavior,” 2021, DALBAR, Inc.
Once investors have identified the big picture of asset allocation, it’s time to further diversify the portfolio. The value of investing in different asset classes can be seen through the randomness of returns on the “Periodic Table of Investment Returns” below. The fact is, nobody knows with certainty in any given year which sectors of the market will be winners, and which will be losers. What we do know is that investing in several different non-correlated asset classes can help reduce portfolio risk and provide a smoother return for investors over the long term.
We view portfolio diversification as a three-step process: 1) deciding which asset classes to invest in, 2) how to weigh each asset class, and 3) how to invest within each asset class. The goal here is to construct a portfolio that reduces unsystematic risk without sacrificing return. Here are just a few of the topics to be considered through the portfolio construction process:
- Equities vs. Fixed Income/Cash
- Domestic vs. International
- Developed vs. Emerging Markets
- Large Cap vs. Mid/Small/Micro Cap
- Growth vs. Value
- Yield Curve and Duration
- Interest Rate Risk vs. Credit Risk
- Active vs. Passive
Although there are critics of Harry Markowitz and Modern Portfolio Theory, there is plenty of research supporting his thesis that asset allocation and diversification are two essential strategies for building a sound portfolio. Please don’t lose sight of this…finding the right allocation for your investments is not a one-size-fits-all approach, it should be tailored to your situation.
About Ballast
Ballast is an employee-owned, financial planning and investment management firm located in Lexington, KY. Ballast provides individualized services to high-income earners, high-net-worth clients, and those individuals/businesses who have complex situations. To learn more about the intricacies of the information above or to learn about our firm, please visit BallastPlan.com, email us at info@ballastplan.com, or call our office at 859-226-0625.
