Asset Allocation Approaches: Building From the Bottom Up

    by James B. Cloonan

    In my column last month, I argued that the popular approach to asset allocation was seriously flawed because it treated asset allocation as an end, rather than as a means to an end. The real objective is risk reduction, and asset allocation is a way to get there.

    The current popular asset allocation approaches divide investments into asset classes—for example, stocks, bonds and real estate. The approach then divides your investible assets between those asset classes based on some formula, which is often related to an individual’s age or life cycle. These approaches also suggest you further divide up your investment dollars among the various sub-classes—for instance, small-cap and large-cap stocks, U.S. and foreign stocks, etc. The next step is allocation among individual stocks. This is normally called “diversification,” but it is really the same concept as asset allocation.

    My criticism is that the popular asset allocation approaches leave out an extremely important step. The ultimate goal is to reduce risk, and there is no question that allocation across asset classes can reduce risk. However, it can’t reduce risk effectively unless you know which investments in each class are involved. As I pointed out, some individual bonds are riskier than the average stock, and certain bond portfolios are riskier than certain stock portfolios. The important issue is how the holdings correlate. What an individual needs to do to reduce risk is to add to his portfolio those holdings that have both good prospects and low correlations with the other holdings. Whether those assets belong to a particular class is not important.

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