Asset Allocation

Asset allocation is an investment strategy that attempts to balance risk versus reward by adjusting the percentage of each asset in an investment portfolio according to the investors risk tolerance, goals and investment time frame.

Many financial experts say that asset allocation is an important factor in determining returns for an investment portfolio. Asset allocation is based on the principle that different assets perform differently in different market and economic conditions.

A fundamental justification for asset allocation is the notion that different asset classes offer returns that are not perfectly correlated; hence diversification reduces the overall risk in terms of the variability of returns for a given level of expected return. Asset diversification has been described as “the only free lunch you will find in the investment game”. Academic research has painstakingly explained the importance of asset allocation and the problems of active management.

Although risk is reduced as long as correlations are not perfect, it is typically forecast (wholly or in part) based on statistical relationships (like correlation and variance) that existed over some past period. Expectations for return are often derived in the same way.

When such backward-looking approaches are used to forecast future returns or risks using the traditional mean-variance optimization approach to asset allocation of modern portfolio theory, the strategy is, in fact, predicting future risks and returns based on history. As there is no guarantee that past relationships will continue in the future, this is one of the “weak links” in traditional asset allocation strategies as derived from MPT. Other, more subtle weaknesses include the “butterfly effect”, by which seemingly minor errors in forecasting lead to recommended allocations that are grossly skewed from investment mandates and/or impractical—often even violating an investment manager’s “common sense” understanding of a tenable portfolio-allocation strategy.

There are many types of assets that may or may not be included in an asset allocation strategy:

• cash and cash equivalents (e.g., deposit account, money market fund)
• fixed interest securities such as Bonds: investment-grade or junk (high-yield); government or corporate; short-term, intermediate, long-term; domestic, foreign, emerging markets; or Convertible security
• stocks: value, dividend, growth, sector specific or preferred (or a “blend” of any two or more of the preceding); large-cap versus mid-cap, small-cap or micro-cap; public equities versus private equities, domestic, foreign (developed), emerging or frontier markets
• Commodities: precious metals, broad basket, agriculture, energy, others
• commercial or residential real estate (also REITs)
• collectibles such as art, coins, or stamps
• insurance products (annuity, life settlements, catastrophe bonds, personal life insurance products, etc.)
• derivatives such as long-short or market neutral strategies, options, collateralized debt and futures
• foreign currency
• venture capital, leveraged buyout, merger arbitrage or distressed securities

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