What is Asset Allocation? To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insight, or inside information. What’s needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework.
“Asset allocation” is an old buzzword among large pension plans. The idea of not putting all your eggs in one basket is widely followed by those responsible for managing defined benefit pension plans for millions of workers. Unfortunately, the lesson of diversification was an expensive one for millions of individual investors who saw their retirement portfolios hammered in the last bear market. For most people under the age of 50, the recent bear market was the first taste of what can happen if you get greedy. Those over 50 were reminded of what risk is. The aggressive investments that Wall street is typically fanatical about selling finally took a back seat to prudence, as most surviving stockbrokers switched hats ad started talking about risk reduction, asset allocation, and long-term investing.
Prior to the 1970s, the mathematical models used to help make asset allocation decisions were foreign to all but a few academic researchers and large pension fund managers. The traditional view of diversification was simply to avoid putting all your money in one place. That meant owning a few bonds in your stock portfolio. But in 1952, Harry Markowitz, a 25-year-old graduate student from the University of Chicago, wrote a revolutionary research paper titled “portfolio Selection” that changed the way people thought about their investment portfolios.
In short, Markowitz discussed the idea that financial risk is necessary in a portfolio to achieve a higher rate of return, but that risk can be reduced through proper diversification of investments. Since this concept seemed elementary, the paper was not viewed as original research by many of his primary instructors. However, what Markowitz did was unique. For the first time, someone mathematically quantified the risk-and –return relationship among stocks in a portfolio and created formulas that predicted how these relationships work together to reduce risk in the future. He argued that the risk of an individual investment is not as important as how the entire portfolio fits together to achieve a positive result. His paper was published in the prestigious journal of finance.
Initially, “Portfolio Selection” had little following and no one at the University of Chicago anticipated that the small, 14-page paper would become the backbone of most portfolio strategies over the next 50years. But, later in the decade, the paper started to be reference in more financial literature. In 1959, Markowitz published a book on the subject titled portfolio Selection: efficient Diversification of investments. The research in that book earned Markowitz wide recognition and eventually the Nobel Prize in Economics in 1990.
As computing power became less expensive, asset allocation research expanded rapidly in universities, band trust historical data, different portfolios of stocks and bonds were tested using computer simulations. The idea was to find the best mix of each asset class that achieved the highest returns with the least risk. This strategy of port –achieved the highest returns with the least risk. This strategy of port folio management became known as modern portfolio theory (MPT).
Today, nearly every professional portfolio manager is trained in MPT and uses the technique to manage money. Individual investors can also advantage of the same risk-reduction concepts, particularly if they use index funds as a base for investment selection. (see Chapters 8 and 9). The reason index funds work so well is because there is a lot of historical data available on most indexes and the cost of implementation is so low. Creating an asset allocation of low-cost stock and bond index funds can reduce the portfolio risk and increase the portfolio return.
MPT In Action
College professors who teach asset allocation theory start by using two asset classes, stock and bonds. In one portfolio, the expected return of the portfolio is increased and risk is reduced. Figures 12-1 and 12-2 illustrate the example using two widely followed indexes, the S&P 500 index and Lehman Brothers Intermediate Credit/Government Bond Index. Various mixes of the two investments are combined at 10% intervals.
Risk is measured as the average difference in annual returns. This measurement is also known as standard deviation. The more volatile a portfolio, the greater the standard deviation. Lower risk is always preferable.