Asset Allocation

Why it is your most important investment decision

Asset Allocation is the process of dividing investments among different kinds of asset classes, such as stocks, bonds, international equities, real estate and cash.

The goal is to diversify portfolio investment holdings across different asset classes that have low correlation to optimize the risk/reward tradeoff based on an individual's or institution's specific situation and goals. A recent study on diversification with the use of sectors has validated that sectors offer better risk/reward tradeoffs compared to traditional asset class breakouts.

"Approximately 92 percent of variability of a funds investment return is due to allocation of assets."

Why correlation is also important

The major asset classes of stocks, bonds and cash have non-correlated risk/return characteristics.  For example, in a very general sense stocks and bonds have a negative correlation.  When stocks are performing well, bonds will not, and vise versa.   Within the equity portion of your portfolio asset allocation wedge, sectors will have varying levels of correlation relationships. Ideally, the equity portion of your portfolio should also be diversified between sectors that are not highly correlated.  Sectors that are highly correlated to the market benchmark indexes are said to have perfect correlation.  In these situations where sector results are highly correlated to the benchmark overall index results it would be better to buy the index and achieve a greater level of diversification.  

R-Squared is a measurement of how closely a portfolio's performance correlates with the performance of a benchmark index, such as the S&P 500, and thus a measurement of what portion of its performance can be explained by the performance of the overall market or index. Values for r-squared range from 0 to 1, where 0 indicates no correlation and 1 indicates perfect correlation.

Determining Asset Classes

The primary purpose for segregating securities into "asset classes" is so that they can be combined together to create "optimal portfolios".  In Modern Portfolio Theory, the efficient frontier is the optimal mix of asset classes that generates the highest return to risk ratio.  Asset classes include:

• MAJOR ASSET CLASSES (equities, bonds, real estate, cash)

• 6 MAJOR EQUITY REGIONS (US, UK, Japan, European Monetary Union, Latin America, Far East)

• BOND TYPES (Corporate, short term, long term)

• 4 MAJOR CURRENCY RISKS (British Pound, Japanese Yen, USD, European Monetary Union)

• INDUSTRY SECTORS

Low correlation reduces risk

The best asset classes to combine in a portfolio all have a low correlation with each other.  How you define a distinct asset class really should be based on a review of its correlation.  The correlation scale ranges from 0 to 1, where 0 indicates no correlation and 1 indicates perfect correlation.  Here are some examples:

• Russell 3000 index and the S&P500 index have a correlation of .99

• the average correlation among traditional size and style breakouts is 90%

• the average correlation among sectors is only 31%

How you allocate your investment portfolio is the most important investment decision you will ever make. 

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