How to Achieve the Right Asset Allocation

It has been my observation that most investors focus on one aspect of investing more than any other—the recommendation, and by that I mean specific security advice.

That is because investors have been trained by brokers and the media from time immemorial to believe that recommendations are the primary road to investing success.

Yes, recommendations are important, but contrary to most people’s belief, they are only the final step in the investing process. Recommendations are less important than the proper asset allocation and diversification decisions that necessarily precede them. This article discusses these first two far more important steps.

If you go to Amazon.com and search the word “diversification” you will find over 2,500 books on the subject. And, of course, diversification has also been discussed in countless magazine and newspaper articles. Not only that, but the science of diversification, unlike many modern day investment strategies, has been an important topic for millennia.

The oldest recorded asset allocation advice may be from biblical times. The Talmud, a record of rabbinic discussions pertaining to Jewish law, ethics, customs and history (circa 1200 B.C.–500 A.D.) recommends: “Let every man divide his money into three parts, and invest a third in land, a third in business, and let him keep a third in reserve.” Today we would call these three asset allocations (or baskets) real estate, common stocks and money funds. You can clearly prosper with that advice right now.

Jumping to more recent history, the fabled Rothschild family had an asset allocation formula that worked well for over a century and that, amazingly, remains totally relevant today. The Rothschilds placed one-third of their wealth in each of three baskets: securities, real estate and art.

Now, the purpose of most investing strategies is to increase profits, but that’s not true of diversification. Its purpose is to reduce risk. If you own your own business, diversification may not be an option. You will probably have all your money in it. But that’s not the case when you invest in other people’s businesses, which is what you do when you buy listed stocks.

When you invest in stocks, you have the choice of diversification or concentrated investing. I realize some people follow the concentrated path in investing—and some of these people become very, very wealthy. But in all likelihood, you will never know enough about the workings of publicly traded companies, or how the actions of other investors will impact your holdings, to be comfortable putting all your money in one, or even a few, stocks. This particularly applies to investing in companies you work for (when they are large enough to have publicly traded stock). Whether you are an expert or layman, when bad things happen, there is really no protection other than diversification.

The Basics

Asset allocation basically means holding various asset classes that have uncorrelated performance; that is, they fluctuate independently of each other. That’s the whole point. If two investments fluctuate in tandem, they won’t provide diversification or reduce risk.

While a portfolio can consist of any number of baskets, the three most important asset classes for individuals are stocks, bonds and cash. (Institutional portfolios have a range of up to 12 asset classes.) Table 1 shows that there is virtually no correlation among the three basic baskets. (Zero is no correlation; +1.00 and –1.00 are perfect positive and negative correlations.) This is critical. You want zero correlation, or better yet, negative correlation. If two asset classes have a high positive correlation, then they are really variations of the same asset class, and don’t increase diversification.

As Table 1 shows, spreading your money among stocks, bonds and cash gives you superior diversification and risk control. You are always at risk, no matter what you do, but with this approach you have dramatically reduced the likelihood of all your investments declining at once. How you allocate among these baskets in your portfolio can determine up to 90% of your returns. This alone tells you where you should be focusing your investing effort.

Now, at this point I know some of you are thinking, “I’m an advanced investor; I’m way beyond this stuff.” Well, maybe you are, and maybe you are not. So I’ve developed a quick test to find out. Of the three baskets, the equity basket is the most volatile and hence the riskiest. Bonds are next, and cash is the safest. This means it makes sense to put your primary effort into getting your equity allocation right.

Question: Do you know right now what percentage of your portfolio is currently invested in equities? Yes? No? If you have to look it up, you don’t know. If you don’t carry that number in your head at all times, you may not be applying whatever you do know correctly—and this article may be of help.

No Single “Right” Allocation

Since the greatest risk is in stocks, you should first look at the amount of money you want to put in that basket. The less you allocate to stocks and the more to bonds, the lower your investing risk should be. Looking at financial assets only, here are my limits on the high side: I would recommend that young people have a maximum of 80% in equities, middle-aged people 70% and retirees 50%.

Regardless of what you choose, the important thing is to know your target asset allocation and either stick reasonably close to it or have logical reasons for not doing so.

Here are some of the factors you need to consider to reach your own personal allocation:

• How many years before you need the money, either for retirement or for other purposes, such as college?
• How long does the money have to last in retirement? Make an estimate.
• How easily can market losses be replaced?
• How much inflation protection do you need?
• Age: Generally, older people should take less risk, but there are some significant exceptions. For most people, age is closely linked to the time horizon.

These factors are really all facets of what is called your time horizon. For most people, that’s the bottom line. In addition, consider:

• Family: How solid is your marriage? What child-rearing expenses are you likely to incur (including college costs and possible wedding expenses)?
• Wealth: This is more important than most realize. It’s dangerous to take substantial equity risks if you don’t have a cushion.
• Income (if you are still working; or cash flow if you are not): How great is it? How stable is it? The more you have, the easier it is to accept risk.
• How much do you want to set aside for emergencies?
• How much money do you want to set aside for charities?
• Stock market outlook: Are you long-term bullish or bearish?
• Are your stocks or equity funds more or less risky than the market?
• How much are you willing to lose without cutting your losses?
• How much volatility can you accept?
• What is your current allocation, and how happy are you with it?
• How closely are your on-the-job earnings linked to the stock market? If you are an investment professional, or work for an investment professional, putting your personal wealth in the market can leave you dangerously undiversified.

When I had my newsletter, The No-Load Fund Investor, we were the number-one newsletter in America on a risk-adjusted basis for the 15 years ending June 2006. But we were never number one on a raw basis. The reason we excelled on a risk-adjusted basis was that we had the best asset allocation. Most other newsletters had equity-only portfolios.

According to a study by T. Rowe Price, for the 15 years ending in 2010, a portfolio 50% in stocks and 50% in bonds had 100% of the return of an all-stock portfolio with only 51% of the risk. Similarly, a 75% stock/25% bond portfolio had 102% of an all-stock portfolio return with just 75% of the risk. This is proof positive of how you can benefit from proper asset allocation.

In the secular bull market of the 1980s and 1990s, it often didn’t matter how much risk an investor took. That’s not true now. That secular bull market ended 12 years ago, and I think it will be many years before the next one begins. Risk-adjusted performance will be the name of the game for the foreseeable future.

If boiling all the above factors down to a single allocation percentage is beyond you, get professional consultation from a fee-only adviser.

Diversify Within Asset Classes

After you’ve established your asset allocation, the next step is to diversify within each asset class. This is sometimes called sub-asset allocation or second-tier diversification. In the stock allocation, for example, it means diversifying among growth and value, large cap and small cap, U.S. and international, and so on.

Sub-asset stock allocations have totally different characteristics than asset allocations. Unlike asset classes, there is a substantial long-run correlation between most sub-asset classes. One institutional study found that when correlating five stock sub-asset classes, the lowest correlation—U.S. core stocks to emerging market stocks—was a very substantial 0.82. Most correlations ran in the high 0.90s. Table 2 shows the sub-asset class correlations within the stock asset allocation.

What these facts mean is that determining sub-asset allocations is far less important than determining asset allocations—and probably even less important than selecting individual stocks or funds.

This is the part of investing where you can take shortcuts and do it the easy way. Here’s how.

Style Diversification the Easy Way

Diversifying by style has become a big deal. Many advisers and many investment publications will go into great detail explaining style diversification. They will admonish you to diversify between growth and value stocks and between large-, mid- and small-capitalization stocks. In my opinion, diversification by style has been tremendously overemphasized in the construction of a long-term investment plan.

It is extremely difficult, at best, to forecast the future, and that certainly includes trying to forecast which styles will be the best performers. Performance leadership in these “style-based” asset classes may run in cycles, but these cycles are far from regular and are difficult to predict.

Furthermore, styles don’t really qualify as asset classes because the differences between styles are usually a matter of degree, not direction. If large caps are going to gain, chances are so will mid-cap and small-cap stocks, just to different degrees. Not only that, it’s a little-known fact that correlations among sub-asset classes are not necessarily the same in bull markets as they are in bear markets. Two examples: According to a significant study by Mark Kritzman, president of Windham Capital Management, published in Peter Bernstein’s Economics and Portfolio Strategy newsletter, growth and value both go down in bear markets, but they don’t gain to the same degree in bull markets. Similarly, U.S. and foreign stocks are highly correlated during bear markets, but far less correlated in bull markets.

That’s a shame. In both cases, we would vastly prefer the reverse to be true: no correlation in bear markets to minimize our losses, and high correlation in bull markets when we want everything to go up.

Table 3 shows the results of a Morningstar study of correlations among Morningstar’s “style boxes” over a 10-year period. With 1.00 as perfect correlation, over half the style boxes correlated to the others at a 0.95 or higher level, and 89% had correlations of 0.90 or higher. The lowest correlation was 0.85 between large-cap growth and small-cap value. These correlations are all very high and positive. Correlations can be computed over various time frames. This study used a very long time frame to give maximum opportunity for the various styles to interplay.

The Two-Fund Solution

The solution to style diversification is simple: Buy them all. Buy both growth and value, and buy all cap sizes. Never hang your hat on one style. This can be done with any broad-based fund, but the simplest way to do this is to buy a total market index fund that has all the styles. That way you don’t have to predict which style will do best, which is a hard task. This works well because, as the table shows, correlations between styles are so high it’s not worth the effort to try to pick the winners.

Total stock market index funds are funds that basically hold all publicly traded stocks. Vanguard has one that owns 3,300 stocks—virtually everything. You can also buy these funds from Fidelity, Schwab and T. Rowe Price. But there’s one minor hitch.

Since most total market funds are capitalization-weighted, these funds wind up effectively being large-cap funds. In the case of the Vanguard Total Stock Market Fund (VTSMX), which is representative of the genre, 66% of its assets are in large-cap stocks, 27% in mid-cap stocks and only 7% in small-cap stocks.

Over the long run, small caps are outstanding performers, and you must not neglect them. To rectify this small-cap underweighting, add a small-cap index fund to the portfolio. I would bring the small-cap weighting up to 20% of your domestic stock portfolio. Possible two-fund pairings are suggested in Table 4.

With this approach, we have taken care of sub-asset diversification with two funds. Now, isn’t that a lot easier than trying to own something in all the nine style boxes, or guessing which style will lead? Leave the style guessing to the fashion world.

Bear in mind, I wouldn’t recommend these total market funds if they didn’t perform. But they do. Standard & Poor’s has just summarized index fund performance for last year and for the last three and five years. In 2011, only 16% of actively managed U.S. equity funds outperformed their S&P benchmarks; 84% failed to. Over the previous three- and five-year periods, only 43% and 39% of actively managed equity funds outperformed their benchmarks, respectively.

Here’s further proof. In late December 2009, the results of a year-long investing contest in the Chicago Tribune were announced. I came in second out of eight contestants. My picks were two broad-based index funds. I beat six pros—with index funds. Only one beat me.

In sum, put more effort into getting the right asset allocation and second-tier diversification, and less effort in picking individual funds and stocks.

This article is adapted from Jacobs' book, “Investing Without Wall Street” (John Wiley & Sons, 2012).

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