Asset Allocation

There are many theories of investing. Think of how different Warren Buffet, who buys whole companies and never sells them, is to a day trader, who buys and sells a stock within the same day. The best investors of each of the many types will make money. But what about the rest of us? We are retail investors. We are the patsy's in this game. In the early weeks of 2008 the market has fallen by over 12% and only NOW we get the emails that we are in or entering a recession. Where were these emails a few weeks ago when we could have been the first to the exits? How can the small investor avoid being creamed by the market?

 First you need a plan that's grounded in common sense; then you need to stick to it. You probably know that the stock market generates the best returns over time based on the earnings of the world's best companies, compared with bonds and cash which earn interest. You probably also know that there's a lot of volatility associated with the market, and that diversification is recommended so that not all of your eggs are in one basket. Well, asset allocation is a method of diversifying your investments based on Nobel prize-winning economic theories, today called 'Modern Portfolio Theory'. It goes like this: 

Each investment or investment type has a risk-return relationship - more risk means more return and vice versa. Some investments have a negative correlation with others, i.e. one goes up as the other goes down. If your basket of investments contains a mix of a half-dozen or so different types of products where some will be up when others are down, the overall growth of the basket will be smoother and with less risk. Such a basket usually includes stocks, bonds and cash. This is diversification.

 It is then possible to optimize the mix of investments for the amount of risk you can take and still sleep at night. Different proportions of each investment type in the mix generate different rates of return for a particular level of overall risk. You identify the proportions that give the greatest level of return. This is called the 'Efficient Frontier'. To create an efficient frontier, apply a mean variance optimizer to the risk, return, and correlations of the chosen asset classes, then run stochastic Monte Carlo simulations for better optimize the asset allocation. Easy, if you have the software.  This is not something most people can do at home, but it's everyday stuff to most investment advisors. By the way, I discuss Monte Carlo Simulations here.  

You end up with a well diversified portfolio with perhaps a better chance of beating the average market returns for your personal level of risk. So that's the plan. 

Now you have to stick to it. 

You may have heard that over longer periods, the ups and downs of the market average out and generate an increasingly certain positive rate of return. At this point, we must say the magic clause, "past performance is no guarantee of future success", but an example would be that a given investment portfolio might have a 15% chance of decreasing by 10% in value in a year, but only a 6% chance of the 10% loss over a 10 year investment horizon. Let's say this is within your comfort zone, and you intend to stick with this investment under these conditions. However, at some point within the first year, there's a 42% chance of a 10% loss, and a 59% chance at some point within the 10 years. The probability of loss at some point within the time horizon is considerably higher than at the end of the time horizon. And whereas the end of horizon loss decreases with time, the probability of loss within the time horizon increases with time.  

This means at some point, the market will be down enough for you to want to abandon the plan in favor of a strategy know as 'Buy high, sell low' - the exact opposite of what you should be doing. The advisor should be there to reassure you and help you stick to your plan.  

Here's what an investment advisor should do for you: 

1) Decide which asset classes to include and which to exclude from the portfolio 

2) Decide upon the normal policy, or long-term, weights for each of the asset classes allowed in the portfolio  

3) Strategically alter the investment mix weights away from normal in an attempt to capture excess returns from important fluctuations in asset class prices (i.e. market timing)

 4) Select individual securities within an asset class to achieve superior returns relative to that asset class 

Note: Bay Area Planners selects and mananges competent investment advisors for 'Active Strategic Asset Allocation', or we will work with your present investment advisor on implementing the retirement plan we prepare for you. 

Return to Free Info