What is ‘asset allocation’ and why should you care?
To view a video version of this blog, please click here.
“Usually expressed on a percentage basis, your asset allocation is what portion of your total [investment] portfolio you’ll invest in different asset classes, like stocks, bonds and cash or cash equivalents.”
One of the most useful publications I’ve come across to help investors understand asset allocation is the annual Periodic Table of Investment Returns published by the Callan Institute each January.
Each column of the table ranks a selection of asset classes from best to worst based on the annual total return. Each asset class has a consistent color code so you can easily scan the table to see how a particular market segment has done over multiple years. Despite the Covid-19 shutdown in 2020 and part of 2021, U.S. stocks have been the clear winner over the past 5 years, with the notable exception of 2022 when cash was king. (See blue boxes in the top row of the table.)
This table makes it easy to see how different the asset returns can be from year to year. Most investors focus on large, well-known U.S. stocks such as Apple or Microsoft to grow their wealth, but we see that international stocks, bonds, and real estate have given U.S. stocks a run for their money during various economic environments in the past.
“An asset class is a grouping of investments that exhibit similar characteristics and are subject to the same laws and regulations. Asset classes are thus made up of instruments that often behave similarly to one another in the marketplace.”
Why should you care? Because you probably will have the opportunity to choose mutual funds or ETFs in a 401k or similar type of investment vehicle through your employer, and choosing wisely can make a huge difference to your retirement income.
First step - be honest with yourself about the degree of risk you’re comfortable taking. Just because stocks have earned the highest cumulative return over most 10-year periods commonly reported, you would have endured several periods of significant negative returns during many of those periods, even as much as a -20% loss in a single day! (October 19, 1987)
The chart above shows the number of years the total return of the S&P 500 fell into different ranges. The green bars show the number of years the return was positive (16) and the red/orange bars show the years the return was negative (8). Though the market return was positive twice as much as it was negative, the negatives were still very painful to live through! (Source: https://ycharts.com/indicators/sp_500_total_return_annual. Author’s calculations.)
How can you manage this risk of loss? Spread your investments across a variety of asset classes which historically provided returns and volatility you are comfortable with and which are not highly correlated.
“Asset correlation is a measure of how different investments move in relation to one another. Two assets that move in the same direction simultaneously are positively correlated, while those that move in opposite directions are negatively correlated.”
The best way to build a well diversified portfolio is to run your asset options through several historical periods to see how they performed. I like to use the efficient frontier analysis at https://www.portfoliovisualizer.com/efficient-frontier, but you can also use stock comparison tools on investment platforms such as Charles Schwab https://www.schwab.com/research/etfs/tools/compare.
While we recognize that each investment period is unique, running your investment options through a variety of periods should provide a reasonable range of expected return, volatility, and correlation on which to base your asset allocation. The table below show the historical returns and correlations of a selection of asset classes based on the period from January 1994 to January 2024.
The relationship between return and volatility is captured by the ‘Sharpe ratio’. Higher is better.
Correlations will range between +1 and -1. Lower is better.
During this period, large and small U.S. stocks generated similar returns, but small stocks were significantly more variable. The correlation between the two asset classes is also close to +1, indicating they move together most of the time. Given these statistics, there’s not much benefit from holding both asset classes in an investment portfolio.
The second and third best assets as measured by Sharpe ratio are bonds. The returns were about half that of stocks, but so was the volatility. Given the low correlation of 0.15 (Total U.S. Bonds vs. U.S. Large Cap), allocating a proportion of your assets to bonds could buffer your portfolio during stock market downturns.
Bottom line - choose a blend of asset classes likely to provide the degree of risk and return you are comfortable with, recognizing that past performance doesn’t guarantee future results! See table below for the historical results of a variety of stock/bond allocations during our sample period (Jan. 1994 - Jan. 2024.)
The highest ratio of return versus risk came from the 50/50 portfolio of stocks and bonds. But if you can handle the likelihood of significant downturns from time to time, go ahead and increase the stock allocation to the point you’re comfortable with.
If you want to be a bit more active with your asset allocation, you can add tactical shifts in the proportion of risky assets vs. safer assets based on valuation and macroeconomic conditions. This strategy is called ‘tactical asset allocation’.
“Tactical asset allocation is an active management portfolio strategy that shifts the percentage of assets held in various categories to take advantage of market pricing anomalies or strong market sectors. ”
For example, in February 2020 stock prices plummeted due to the Covid-19 shutdowns. In March 2020, the Federal Reserve dropped interest rates near zero to help consumers pay their bills when they weren’t able to work. As a result, stock valuations (prices) were exceptionally low and bond valuations were high going into the spring of 2020, causing dividend yields on many stocks to be higher than the expected return (yield) on most bonds. (Source: Morningstar.com)
Investors with a tolerance for market volatility would have benefited from increasing their allocation to stocks and decreasing their allocation to bonds in the spring and summer of 2020. Even if stock and bond prices didn’t change, the difference in yield would make stocks the better choice as long as the companies issuing the stock continued to pay the dividend. And if the U.S. economy recovered, as it eventually did, stock prices should increase and bond prices should fall, which they also did, making the shift in asset allocation profitable for the investor.
The chart below shows the return of the SPY ETF (proxy for the S&P 500 stock index) and the AGG ETF (proxy for the Bloomberg Aggregate bond index) from 5/29/2020 to 5/28/2021. (Source: Morningstar.com) Though the ride up was certainly bumpy, stocks returned more than 10x the return of bonds during this period. Though you won’t always to be right, returns such as this can happen when you invest at a time when stock or bond valuations are either too optimistic or too pessimistic.
But beware! Tactical asset allocation involves forecasting broad macroeconomic shifts and the reaction of stock and bond investors over a future time period, which even professional economists and investors get wrong on a regular basis. This strategy should be used only when market conditions are extreme enough that you believe the probability of being right more than outweighs the consequences of being wrong.
Whether you choose a passive asset allocation or a more tactical strategy, making a reasonable effort to create an appropriate investment portfolio is much more likely to lead to a solid financial future than not investing at all. Be honest about your capacity for investment losses, and get advice from a trusted professional before diving in with both feet.
Marcia Lucas, CFA
MarciaLucas@Person-to-Person.net
