HOW TO ALLOCATE ASSETS PRUDENTLY
Asset allocation is the process by which an investor selects asset classes and decides how much to invest in each class such as domestic equities, international equities, real estate, taxable bonds, municipal bonds, money market securities. On the other hand, security selection is the process of choosing which securities to buy within each asset class. Studies indicate that asset allocation is usually a much more important determinant of portfolio performance than security selection.
This article provides an intuitive overview of prudent asset allocation. There are two broad objectives to asset allocation: lower risk and higher return. Put differently, asset allocation is the task of earning attractive returns without suffering losses from bearing risk.
Let’s look at risk from an economist’s perspective. A modern economy inherently contains substantial financial risk both due to the failures of individual ventures and the natural tendency of economies to go through tough periods of recession or even depression. Nobody wants to be the one who suffers large losses when the economy sours. But the risk has to be borne by someone. Bearing risk is a painful but necessary service to the economy. In a market economy the prices of riskier assets adjust so that the investors who bear the most risk tend to earn the highest average returns in the long run.
For almost a decade one thing has been clear to U.S. investors: if we put all our money in an ultra-safe location such as a money market security, we will receive a negative return after including the effects of inflation and income taxes. If we are to beat inflation and taxes we must be willing to bear risk. Prudent asset allocation requires that we chose those risks carefully.
Current market conditions – likely to persist for a decade or two – dictate that investors seeking positive returns after inflation and taxes must view bearing substantial risk as a necessary evil. Therefore, investors should use the asset allocation process to assemble those risks that appear to offer the highest expected returns per unit of risk.
There are two principles of prudent asset allocation: reducing risk through diversification and enhancing returns through wise levels of risk exposures.
Diversification is a top priority because it reduces risk without reducing expected return. Wise investors usually diversify within asset classes. But they also diversify broadly across markets and asset classes.
The best way to view asset allocation is to view the process as selecting a variety of attractive risk exposures. The idea is to diversify among various types of risk with an emphasis on bearing those risks that appear to offer better rewards for bearing risk. There are numerous types of risk to select from including equity prices, interest rates, credit spreads, commodity prices and so forth. Prudent asset allocation involves careful analysis of risk-return relationships across a spectrum of asset classes with the goal of assembling a broadly diversified portfolio that taps into assets offering attractive risk premiums.
How can investors identify those asset classes that offer the best risk-return tradeoffs? It is not easy. History suggests that the primary risk worth bearing is the risk of equity market investing. So an investor with a long-term investment horizon who is able to tolerate risk should consider aggressive allocations to investments exposed to equity market risk. But equity valuation levels are reasonably high by historic standards, and it is quite risky for an investor to put “all the eggs” in the domestic equity basket. So for starters, U.S. investors might find lower risk by including international equities in their portfolios. Other risks such as credit risk have a modest history of offering substantial rewards.
Some risks such as interest rate risks offer little hope of attractive returns and high chances of devastating returns in today’s markets. For example, with 30-year Treasury bond yields below 3% the risks are very high while the potential benefits are so modest that there is little chance that the bonds will outperform inflation on an after-tax basis. The bottom line is that asset allocation deserves careful attention by investors and their advisors.