Asset Allocation -- Friend or Foe?

Asset allocation is essentially the notion that you can minimize your overall investment risk and increase your potential for gain by spreading your investment dollars across various types of investments. Does it work? Yes and No. Traditional Asset Allocation protects you both from losing and making money. If you are looking for higher safety and higher returns, a better bet is Mutual Fund Switching and conservative trend following Market Timing .

First of all, the financial planning community loves asset allocation because of its impeccable breeding. Its origins come from a study by Harry Markowitz. Yes, the same Markowitz that later earned, along with William Sharpe, the 1990 Nobel Prize in Economics. Their work became a foundation for financial economics. They essentially pioneered the Modern Portfolio Theory. However, as impressive as it sounds asset allocation does much more for risk than the return.

Asset allocation reduces risk.

Yes, asset allocation does reduce risk but at the cost of almost all portfolio return. The basic idea is that by investing your dollars in different asset classes, bonds, stocks, precious metals etc, the investor diversifies their risk. Put another way: Don't put all your eggs in one basket. This safety by diversification rests on the idea that these markets go in different directions at different time. Usually, this is true but not always, especially at market extremes when the protection is needed the most. There are times when equities, bonds and gold stocks all go down or up together. In the crash of 1987, when the mutual fund investor allocated their assets between gold funds, stocks and bonds they were in for a shock. When the crash hit, their bond portfolio was extremely underweight due to the year long rise in interest rates. You already know what happened to their stock portfolio. The gold funds, which are supposed to be the shelter from the storm, dropped as fast as the stocks. Asset Allocation sounds logical on the surface, but think of it like playing every bet on the roulette table. You'll win some. You'll lose some but in the long run only the house, Wall Street, wins.

Asset allocation reduces return.

While asset allocation does an adequate job of reducing portfolio risk by investing across asset classes, the returns are usually muted by the zero sum game. If the investor divides their accounts evenly between assets when one goes up the other goes down, the results, minimal or no gain. If not in even portions, deciding how to divvy up between the asset classes is usually dictated by the age of the investor. For the younger the investor, the more time they can let the portfolio work, the more weighting usually goes into stocks. Weighting more towards one asset class than the other is really blind Market Timing . But, it will increase the gain if the correct asset is chosen. Remember, asset allocation, a relatively new concept, has never been through a prolonged decline. The greatest fault of asset allocation it its premise that the investor will consistently rebalance their portfolio by moving funds out of the productive growing asset and into the declining asset in order to keep their diversification strategy intact. Unfortunately, one hundred and fifty years of investor behavior proves differently. At the end of 1999, a few months from the top in the stock market, the asset allocators should have been net sellers of equities and buyers of bonds. Did it happen, NO. Which proves almost humanly impossible to sell something when the asset class is increasing in value and buy the asset that is decreasing in value. So while asset allocation may make sense on the surface, a closer look shows that it offers little reward, goes against human nature, and is immensely hard to execute. However, with a small amount of fine tuning the basic principals of asset allocation can be turned into the new Asset Allocation for the 21 st century .