Asset Allocation Explained
ASSET ALLOCATION IS NOT INFALLIBLE
You may find negatively correlated asset classes in your search for investments. But that is not the only reason to invest in that asset class. Every investment in your portfolio should be expected to earn a positive return over inflation in the long term. Consequently, an asset class that has negative correlation is of little use if the returns are at or below inflation, and you should discard it and move on. A negatively correlated investment may lower overall portfolio risk, but if it also lowers your portfolio returns, that is not a good thing in the long term. You cannot eat lower risk.
Here is the bottom line. It is basically impossible to find two negatively correlated asset classes that both earn positive returns over inflation. That being said, it may be possible to find a few asset classes that are noncorrelated with each other, and at least have enough varying correlation so that there is relatively low cor-relation on average during most 10-year periods.
A well-diversified portfolio includes several investments with varying correlations (see Part Two for details on investment selec-tion). Some of those investments will be moving out of sync with the rest of the portfolio, while others are moving together. No one knows when any particular investment will become more corre-lated or less correcorre-lated with the others, which is why it is prudent to own several dissimilar investments. Having several types of investments with varying correlations will provide the overall MPT benefit you are looking for.
By studying asset-class correlations among investments that are expected to have a real rate for return over inflation and employing an asset allocation strategy using those investments, you will reduce the chance of a large portfolio loss and reduce port-folio risk over time. However, you will not eliminate these risks.
You cannot eliminate all risk from your portfolio even if you have several investment categories in your portfolio.
There will be periods of time when even the most broadly diversified portfolios will lose money. When those periods occur, there is nothing an investor can do short of abandoning the entire investment plan, which is not a good idea. Trying to guess when down periods will occur and adjusting your portfolio accordingly will probably lose you more money and cause you
more frustration than sticking with your plan and pushing through the storm.
Figure 3-13 provides an example of how 50 percent intermedi-ate-term Treasury notes and 50 percent S&P 500 performed annu-ally. The histogram covers all 60 years from 1950 to 2009. Most years the return was between negative 5 percent and positive 25 percent. The worst year was in 2008 with a negative 11.9 percent return, and the best year was in 1954 with a positive 27.7 percent return. There were 11 years out of 60 when the returns where nega-tive. That is about 1 year in 5.
A single-year loss in a portfolio does not signal the failure of an asset allocation strategy. Rather, losses must be expected to
1 3
7
9 9
13
9
7
2
<⫺10% <⫺5% ⫺5% to 0% 0% to 5% 5% to 10% 10% to 15% 15% to 20% 20% to 25% >25%
Annual return
Number of years
F I G U R E 3-13
Annual Return Frequency Distribution 50% Intermediate-Term Treasury Notes and 50% S&P 500, 1950–2009
occur on occasion. However, for those who expect to make money every year, losing periods such as those that occurred in 1974, 2002, and 2008 can lead to the failure of an investment plan. By failure, I mean that the investor abandons his or her long-term strategy because he or she has lost money. You will lose money during your investing life and should expect to at times. It is better to prepare for it now so that you will not do permanent damage to your investment plan when losses occur again in the future.
If there is one thing that is certain in the financial markets, it is that there will come a time again in the future when even the best investment plan loses money. If you implement an asset allocation strategy and fully understand the risks and limitations, then you are well on your way to achieving the hidden diversification benefits that Harry Markowitz wrote about more than half a century ago.
CHAPTER SUMMARY
Portfolio diversification is the practice of buying several different investments to reduce the probability of a large loss in a portfolio.
Asset allocation involves estimating the expected risk and return of various categories of investments, observing how those asset classes interrelate with one another, and then methodically constructing a portfolio of investments that have a high probability of achieving your goals with the lowest level of expected portfolio risk.
No asset allocation is perfect. Correlations between asset classes change over time, and this causes changes in the diversifi-cation benefits. There may be periods when a diversifidiversifi-cation effect is small, and there may be times when the benefit is large. No one knows when correlations will change or by how much. Sometimes investments in a portfolio become less correlated with each other, and other times they become more correlated. Thus it is wise to hold several different investment types in a portfolio at all times;
however, they should have a long-term positive expected return over the inflation rate.