Risk is not the same as volatility
The first principle is that ‘volatility’ is not ‘risk’. Volatility is backward looking and measures an asset’s variability (how much its price moves around). Risk, however, is the potential to lose money and not recover.
Market efficiency is the golden principle of all asset allocation cornerstone principles. Without some degree of market efficiency, we would not employ asset allocation and would probably focus instead on security selection. Fortunately, our financial markets are highly efficient and are becoming even more so as information technology gets better with time.
Underlying asset allocation are two highly influential and well-known investment concepts: modern portfolio theory and the efficient market hypothesis.
Identifiable Financial Goals
Asset allocation is the strategy of dividing the assets within a portfolio among the different asset classes, seeking to achieve the highest expected total rate of return for the level of risk you are willing and able to accept. As a result, knowing why you are investing and what you are attempting to accomplish is the vital first step. You cannot hit a target you are not aiming for.
Expected Total Return
Expected total return is simply your forecast of total return for each asset class and asset subclass during the future holding period. While past performance does not guarantee future results, using historical rates of return in lieu of estimating expected rates is not only quick and easy but also a prudent approach used by many financial professionals.
Once your risk tolerance has been identified, you then design your portfolio to maximize your expected total rate of return for the given level of risk you are willing, able, and need to assume. This task cannot be accomplished without an estimate of future returns. This is the essence of the risk-and-return trade-off profile. Without a clear understanding of expected total rates of return for each asset class, there is little hope of maximizing a portfolio’s potential performance and building your optimal portfolio.
The term correlation refers to how closely the market prices of two investments, or, in the case of asset allocation, the prices of two asset classes move in relation to each other. Although not always the case, most securities within an asset class or asset subclass tend to move together over time. Of course, there are always exceptions.
Optimal Asset Mix.
Asset mix refers to both the asset classes and asset subclasses that a portfolio is allocated to and their respective weightings within that portfolio. It is essential to allocate a portfolio’s assets in a deliberate and calculated way in order to develop the desired risk-and-return trade-off profile. Thus, allocating assets to those asset classes and asset subclasses to develop the desired risk-and-return trade-off profile defines the optimal asset mix.
The market cycle leads the economic cycle
The final principle is that history has shown us that weak economic conditions don’t always lead to weak future share market returns. If you aim to buy assets when the economic cycle is strong and sell them when it’s weak, you may inevitably miss out on opportunities and be exposed to risks. It would, however, also be unreasonable to assume that the macroeconomics and earnings have an insignificant impact on future market returns. Indeed, a sustained and durable move higher in shares requires strong support from earnings growth and a healthy macro backdrop.
Over time, a portfolio’s asset mix, including the resulting risk-and-return trade-off profile, will change due to price fluctuations, with some fluctuations being quite large. To address this issue, reoptimization may be appropriate and needed. Reoptimization is comprised of four different, but somewhat similar, tasks. Think of these tasks as the Four Rs of Reoptimization: reevaluating, rebalancing, relocating, and reallocating.
- Rebalancing is the task of selling and buying investments in order to return a portfolio’s current asset class mix to the previously established optimal asset mix. Tax implications should be considered when implementing a rebalancing strategy.
- Reevaluating is the task of examining recent changes in your life and evaluating them within the context of your portfolio.
- Reallocating is the task of adjusting to which investments your contributions go and in what amount. In this context, reallocating does not change the mix of your assets, only how contributions will be made in the future.
- Relocating is the task of exchanging certain assets for other assets without changing the overall asset mix or risk-and-return trade-off profile.
It is important to apply the principle of diversification in order to minimize risk in a portfolio. The task of diversifying a portfolio should be addressed after completing the process of allocating among asset classes and asset subclasses. Diversification is the process of investing in a significant number of not-too-similar investments within each asset class in an effort to reduce the risk associated with each individual investment. By holding a significant number of not-too-similar investments, the impact resulting from a negative investment-specific event may be minimized. It is important to understand that the process of diversification entails investing in a significant number of not-too-similar investments with similar risk-and-return trade-off profiles. In doing so, your risk-and-return tradeoff profile will remain constant. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
Risk-and-Return Trade-off Profile
The trade-off between investment-specific risk and return is central to the application of asset allocation theory to an investment portfolio. Risk and return are unequivocally linked, and one simply cannot earn an excessive return while assuming a corresponding low risk. In basic asset allocation theory, the higher your risk tolerance, the higher your potential returns. You should not assume higher risk for the same potential return that a less risky asset may offer. The message here is that you need to build a portfolio with the maximum expected potential total rate of return given the level of risk you are willing, able, and need to assume.
Time horizon plays a significant role in estimating asset class returns, risk levels, and price correlations. Accurate forecasts are essential to building an optimal portfolio. The primary use of time horizon is to help determine the portfolio balance between equity assets and fixed-income assets and cash and equivalents. All else being equal, the longer your investment time horizon, the more equity investments and less current income-producing investments you may consider holding. Conversely, the shorter your investment time horizon, the more current income-producing investments and less equity investments you may consider.
Investor Risk Profile
Your optimal portfolio is designed based principally on your willingness, ability, and need to tolerate risk. Consequently, once your risk tolerance is determined, your optimal asset mix can then be established in order to maximize your portfolio’s return potential. This concept is expressed as the risk-and-return trade-off profile. Personal preferences toward risk assumption play a vital role in determining your willingness to tolerate risk. For example, two different investors with the same level of wealth and the same specific goals and needs would each have a different preference for assuming risk.