Allocation of assets: does it work?
Allocate your assets only to those sectors that perform well.
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A study in the Financial Analysts Journal points out that asset diversification on the average accounts for 93.6% of the variation in a portfolio’s total return. Every money manager is inundated with computer programs to help with asset allocation and to demonstrate model portfolios with correct diversification. Conceptually, most people have a very good understanding of the importance of asset allocation.
If your mother has an asset mix of 20% stocks and 80% bonds, but your nephew has an asset mix of 80% stocks and 20% bonds, over a period of time these two portfolios will perform very differently. Furthermore, the difference in returns will be accountable more by the asset allocation decision than by what particular stocks or bonds your mother owns versus what specific stocks your nephew owns.
In the 1980s, portfolio managers and investors spent most of their time determining how much General Motors they owned, as compared with how much Ford they owned. Investors would hire several money managers, resulting in an asset mix from that microdecision. To day many investors, and many portfolio managers as well, still are concerned about asset allocation models, sometimes to the detriment of total returns.
Differences in opinion
I believe there are far more important variables affecting long-term performance than those concerning how much of a particular company is in your portfolio or whether you are relying upon someone’s personal opinion of the correct allocation model. Such an opinion as to what allocation is to be made among international equities, cash, bonds or large cap versus small cap stocks can be costly. I do not believe that a portfolio should be invested in every sector all of the time.
I ask my clients how much money they have in the stock market? How much money do they have in the bond market? How is that money allocated to various sectors within those markets? These are decisions that will determine long-term performance. It is much more important to own the best-run dominant companies in the most promising sectors of our U.S. economy than it is to be exactly diversified per a computer allocation model.
Asset allocation for your portfolio must be based upon your tolerance for risk. It may seem appropriate for one investor to allocate a portion of his/her assets to preferred stock or blue chip stock, or even bonds. This investor may have trouble sleeping at night with what he/she considers “risky” securities. And what one investor considers “risky” is not at all what other investors consider risky. However, allocating to a sector composed of companies whose earnings and future outlook are declining will dramatically reduce returns. If you are uncomfortable with a large portion of your assets in the technology sector, allocate more of your funds to other top sectors such as retail clothing, the finance and investment sector or pharmaceuticals and the leisure sector.
A mind of its own
Money seems to have a consciousness of its own. Money will migrate to those sectors where it is best received and rewarded. Those sectors change. For best long-term performance results, it is imperative that you or your portfolio managers allocate most of your assets to some of the top 50 or so sectors of the 160 sectors in our economy. Invest in sectors that are rising in relative value, not falling.
For the past 5 years the best sectors for investment have been in the United States. We have a stable government with strong currency and rising productivity. It makes no sense to allocate money to foreign markets based upon some computer diversification or allocation model.
The small cap market has been negative due to poor liquidity. I feel that except for brief periods of time, unless these liquidity problems are ad dressed, this market will continue to perform poorly over the near future. This will require a change in the over-the-counter market-maker system. I do not see that problem being corrected by our exchanges any time soon.
Today some of the best performing sectors of our economy are in such arenas as media-cable, finance and investment, electric laser systems, Internet software, telecommunications equipment, cellular systems, and medical generic pharmaceuticals. Performance is measured by the risk-return ratio. Risk does not apply only to stocks. Bonds are risky. Cash is risky. In managing risk, it is most important to preserve capital. Of course, it is equally important to preserve buying power of that capital. If you are in certificates of deposit at 5.3% or Money Market funds at 4% return, you are not preserving buying power. Your portfolio under these conditions is barely keeping up with inflation net after taxes, not increasing your purchasing power.
Bond prices fall as interest rates rise, and bond prices rise as interest rates fall. As interest rates fall, bonds with a higher rate of interest are called to be replaced by lower interest bonds in refinancing strategies. Because bonds mature over 10 to 20 years, it is a misconception that it is not possible to lose money in this arena. It is very possible! If you hold a growth stock for 10 to 20 years, history dictates that it will usually be worth far more than a bond held for an equal time. What’s more, if you sell your bond within 6 months or 1 year of purchase, chances are that it could be worth less than you paid for it.
A global market
The world is a global market. Technology has made the same information available throughout the world at the same second. Because all of our lives and all of our markets are so intertwined, it is my opinion that the diversification models of the past no longer produce positive results based upon the indices. These diversification models err in that they allocate funds to every sector, regardless of current performance. The portfolio always holds some cash, some foreign equities, some large cap stocks, etc.
I believe it is imperative to allocate your assets only to those sectors that are performing well. Move funds out of those sectors that are not performing well. This means purchasing the top companies in those sectors that are moving up and not being represented in the bottom sectors. Some of my colleagues argue that this is not good diversification. My experience has been that it is much better diversification, and that it certainly produces excellent return on investment dollars!