What is Asset Allocation?
Asset allocation is dividing an investment portfolio on a percentage basis among different asset categories. The concept is when some asset categories are going down, others will be increasing. By combining assets with low correlation the volatility (risk) of the portfolio as a whole is lowered. This makes asset allocation the single most important element of investment management.
Ecclesiastes 11:2
Divide your portion to seven, or even eight, for you do not know what misfortune may occur on earth.
Dividing Assets
There are many different ways of dividing assets. I have chosen 8 major asset categories as examples of categories an investor should consider as part of an investment portfolio:
Cash and Cash Equivalents – Cash provides an asset category with a zero correlation to most assets and provides preservation of capital in bear markets. The zero correlation makes cash an important asset allocation category even in periods of low interest rates.
Fixed Income – examples include Certificate of Deposit (CD’s); U.S. Treasury Bonds, Notes, and Bills; Treasury Inflation Protected Securities (TIPS), Corporate Bonds, and Foreign Bonds – Historically bonds have had a low correlation with other major asset categories.
Domestic Large & Mid-Cap Stocks – historically dividends provide more than half of long term portfolio returns. Look for large and mid-cap stocks with solid balance sheets , and growing cash flows.
U.S. Small & Micro-Cap Stocks – due to the difficulty of researching, and the higher risk of small and micro-cap stocks, investors should consider the advantages of ETF investing. ETF’s provide a low cost means of diversification in the small and micro-cap stocks.
Foreign Developed Markets Stocks – The value of including foreign stocks is a greater universe of choices. In addition the correlation of these stocks might be lower than owning all domestic stocks, providing some additional diversification. Both individual common stocks and ETFs are appropriate vehicles for this asset category.
Emerging & Frontier Markets – Recent trends of emerging and frontier economies embracing free market economics has tilted the developed markets or emerging markets debate in favor of more investment in developing emerging economies. Here again I favor using ETFs for investing in this asset category.
Precious Metals – have the advantage of having a lower correlation with many other investments. Investing in alternative asset investments, including precious metals, can be very volatile and provide both opportunities and risks.
Real Estate – Depending on the size of your portfolio, many investors who own real estate directly, including their home, may want to ignore this in their investment securities portfolio. The concept of owning different assets is diversification and for many investors the real estate they own would be more than sufficient diversification. If not, Real Estate Investment Trusts (REITs) are readily available.
Minimize Asset Class Correlation
Asset correlation is important because a portfolio manager can combine asset classes to minimize correlation and lower the volatility (risk) of the portfolio as a whole. This allows the portfolio manager, willing to take a given amount of risk, to invest in higher reward/higher risk assets. This is called portfolio optimization.
How many asset categories are in your portfolio?
| AAAMP Blog by Ken Faulkenberry | |
|
Ken Faulkenberry earned an MBA from the University of Southern California (USC) Marshall School of Business with an emphasis in investments. Ken has 25 years of investment experience and is dedicated to helping people with self-directed investment management through the Arbor Investment Planner. His asset allocation strategies have an outstanding performance record. |
 |
{ 5 trackbacks }