Asset Allocation - the basics
- Tuesday, May 09, 2000
Written by Scott Kubie, CFA.
Asset Allocation is one of the cornerstone ideas of investment management. It is often expressed in the adage "Don't put all your eggs in one basket." Another expression of the same idea, although from a time prior to capital markets is found in Ecclesiastes 11:2 (NIV)"Give portions to seven, yes to eight, for you do not know what disaster may come upon the land."
Asset Allocation involves the spreading of your investment assets amongst multiple investments based on different combinations of size of the company, location, sector, growth prospects, valuation, type of security, and sensitivities to external factors such as inflation, interest rates, and economic growth.
The prudence of asset allocation stems from basically two sources. The first is the great challenge of predicting future returns from various investment choices. It is exceptionally difficult to predict what is going to happen in the future. No one really knows what exactly will occur. Because of these challenges, it makes sense to spread your investments across multiple areas of the market. Then, if your prediction that a certain segment of the market will be the strongest turns out wrong, your financial situation will not be irreversibly damaged.
The second reason asset allocation is prudent is because you, the investor, are not always a truly rational being. People hate to admit this, but it is true. Take two investments, one goes up 60% in the first quarter, down -50% in the second quarter, up 70% in the third, and a "tame" down -20% in the final quarter. Another investment is much steadier and rises 2% each quarter. Because of compounding returns, the first investment returns just under 9%, while the second returns just over 8%. Which one would you rather own?
The answer to that question is easy: the first asset because it made more money. Even though it went up and down a lot, it had a higher return and investors prefer more money to less, so it is the better investment. Some of you probably chose the second investment because it less painful to watch its return. The question, however, is flawed. The more appropriate question is: what asset do you want to own in the future?
An asset that moves around like the first investment may cause you to worry unduly, lose sleep, panic or any other number of emotional responses. In fact, you might have sold in the worst of the downturn during the second quarter and end up losing substantial money. We all have difficulty owning such a volatile investment in our portfolios. The first asset obviously has lots of potential, but it also carries a lot of risk.
Asset Allocation allows us to have a portion of our portfolio in different areas that have greater potential with a preference for two things, first is assets with good return potential and second assets that don't move the same way at the same time. By spreading our assets out amongst many different segments, when one moves down more than normal other investments will moderate the impact of the one security on the portfolio. The end result is you will be able to persevere through the downturn and take full advantage of the potential return each investment has to offer.
In my next column I will provide a series of portfolios and examine how well diversified each portfolio is for the average investor.
Scott Kubie is featured this week on My Investigator as our Featured Advisor. He is a Certified Financial Analyst and President of Values Asset Management, a registered investment advisor based in Omaha, Nebraska.
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