The seemingly infinite number of investment options available today may leave some people feeling daunted about choosing the right securities to meet their financial goals.
The key might be to focus less on the selection of specific securities and more on the actual distribution into different classes of assets, giving way to the concept of asset allocation.
Asset allocation is built on the principle of balance, which is achieved through diversifying capital into different broad categories of investments. Finding the right allocation requires understanding an individual’s specific risk profile, needs and expectations.
Because these characteristics are unique to each investor, there is no standard formula for finding the appropriate distribution for each individual. Nonetheless, research suggests that asset allocation is one of the most, if not the most, important decision any investor will make. Extensive empirical academic studies have concluded that a portfolio’s preset asset allocation explains more than 90 percent of a well-diversified portfolio’s return variability.1
Asset allocation is one of the most important decisions any investor will make.
This work has been further confirmed by Vanguard research2, suggesting that a portfolio’s investment policy is an important contributing factor to return variability.3 Specific investment selection should therefore become a secondary task for any advisor structuring a portfolio, because asset allocation tends to be the main determinant of results.
An investment strategy, then, should start with the setting of an objective which incorporates reasonable expectations for risk and return. Once that is done, asset allocation plays its important role in controlling the risks associated with each individual asset class.
In the long run, equities seem to outperform any other financial asset class, but due to the variability or deviation of stock market returns, the probability of out-performing in any particular year is not high. For this reason, asset allocation should also include investments with more predictable cash flows. As a result, the probability of achieving expected results becomes increasingly higher, while risk is reduced.
Using a “bucket approach,” where each bucket represents an asset class and behaves differently under specific market conditions, may be helpful. Each investor de- fines how much to “pour” into each bucket, depending upon the level of exposure he or she is willing to have to the characteristics of each bucket, and to personal market expectations.
As an investor yourself, you should avoid market “timing,” as the idea is to have exposure to all buckets. Instead, you’ll be wise to build a sound foundation through asset allocation, which will allow you to weather almost any type of market scenario. Ultimately, results may hinge, not on how much you might earn, but how much you may avoid losing. Losing more means that returns have to compensate for that loss and then give you even more, to maintain a consistent and meaningful return.
Making sound investment decisions, in other words, tends to be less about accurate predictions and more about appropriate asset allocation, controlling risks and keeping costs down.
1 Brinson, 1986; Ibbotson and Kaplan, 2000
2 see Davis et al., 2007
3 Hood, 2005
This article was contributed on behalf of Hallmark Capital Management, Inc. (Hallmark) by Felipe Restrepo, CFP®, vice president and client relationship manager at Hallmark, Miami, Fla. This article is not intended as investment, legal, accounting or tax advice. Any opinions, recommendations or indications of past performance contained in this article may be subject to risks and uncertainties beyond the control of Hallmark Capital Management, Inc. (Hallmark) and are no guarantee of future returns. Hallmark does not guarantee or certify the accuracy, completeness or timeliness of the information presented in this article. Hallmark is an investment advisor registered with the U.S. Securities and Exchange Commission. Registration with the SEC does not imply that Hallmark or any individual providing investment advisory services on behalf of Hallmark possesses a certain level of skill or training. © Hallmark Capital Management, Inc. All rights reserved.
This article was originally published in the February–April 2017 issue of Worth.