How the Smart Money Invests

Asset allocation – the smart strategy to construct your portfolio

Many people still cling to the belief that the best way to manage their money is to either pick stocks themselves or pay stock brokers or mutual fund managers who only result in doing a substandard job. However, for many years, the wealthy and sophisticated investors with the means to hire the most elite money managers have achieved superior returns with a very different method of investing that was developed by Economics and Finance Nobel Laureates. This method is broadly knows as “Modern Portfolio Theory,” and the key to its success lies in the use of asset allocation. Harry Markowitz is considered the father of Modern Portfolio Theory, and won the Nobel Prize for this work. Since that time, numerous other academics have provided research in the area, many becoming Nobel Laureates in the process.

Asset allocation is the process of splitting up your investment money in to types of investments, to create an overall portfolio that seeks to minimize risk and maximize returns. While many people believe it’s all about which stocks you own, the truth is that investment success is more dependent on which “asset classes” you choose.

For example, in the world of finance, the 1986 Brinson Study “Determinants of Portfolio Performance” is often cited as the case for asset allocation. This study determined that greater than 91 percent of portfolio performance comes from portfolio design (asset allocation) while less than 10 percent of performance is derived from individual security selection and other factors.

In building our portfolios, we use the theories and methods of some of the smartest finance people in the world. Many investors simply have not had access to these investment methods because the tools for structuring, managing and rebalancing an ETF or passive asset class fund portfolio have not been readily available or affordable. Stock brokers and commission based advisors do not use these investments for their clients, because they do not pay commissions to the broker.

We do not use individual stocks, or commission based load mutual funds in our portfolios. We use only ETF’s or no commission passive asset class index funds. Why? Several reasons. First, when you own an individual stock, you have no control over bad news or unexpected events that can destroy the value of your investment over night (think, Enron, Worldcom, Bear Stearns, Wachovia, Washington Mutual, Lehman Brothers, BP and a host of others). Why take that risk. When we build a portfolio with asset classes, each “class” might be comprised by an ETF or index fund that owns hundreds of stocks. Bad news for a couple contained in the fund would be nearly meaningless to your portfolio. Also, by owning entire classes of assets, we can direct money to specific sectors or areas that are experiencing strength as a group.

The secret to asset allocation is that the different asset classes we invest in do not act the same way (they are inversely correlated). This means that when some zig, others zag. For example, you want to have some assets that still tend to perform well, even when the stock market is declining. This helps mitigate risk and reduce losses.

It is also important to consider that we live today in a global economic environment. It is no longer necessary or even smart, to limit investments to the United States alone. Today, international and emerging markets are up and coming economic powers, and are poised for substantial growth. In addition, gold, precious metals, commodities, and hard assets should be a part of many portfolios to hedge against inflation or devalued currency during volatile times.

A well balanced portfolio today might contain a number of asset classes such as large cap, small cap, international, emerging markets, commodities, and foreign and domestic fixed income. Of course, the specific investment vehicle and the amounts of each will depend on each client’s situation, and, are subject to continual review and rebalancing as personal, economic or global conditions change.

The key involves implementing a sophisticated asset allocation strategy with a globally diversified portfolio, keeping investment costs low and rebalancing the portfolios as markets ebb and flow.

MPT with a twist
Active Asset Allocation Strategy

Typically, MPT has been a buy and hold strategy, with periodic rebalancing. While periodic rebalancing of asset classes is critically important, and a discipline we rigorously follow, it is our belief that a strict “buy and hold” philosophy, can allow devastating losses to a portfolio that might take years to recover. We have therefore developed an active asset allocation strategy instead of a buy and hold strategy for clients with a shorter investment horizon to retirement, or who have a very low risk tolerance. The key to a successful active asset allocation strategy is to continually analyze what the most effective mix of investment opportunities is. This involves fundamental research, keen awareness of the domestic and global economic environment, and technical market analysis to determine the risk and reward status of each asset class. Next, while maintaining a properly diversified portfolio, we may over weight our allocation to assets with good value and an under weighted assets that are not performing, or bear undue risk.

Active asset allocation strategy gives an investor the opportunity to keep losses small in a bear market. By avoiding large losses in a portfolio, an investor not only loses less money, put preserves capital to take advantage the next opportunities. For example, if an investor loses 50% of a portfolio, it takes a 100% gain just to get back to breakeven. If an investor loses 10% of a portfolio, it only takes an 11% gain to get back to breakeven.

An active asset allocation strategy has kept us under weighted in equities during extended market declines, and allows us to participate during upward trends. This tends to greatly reduce portfolio volatility (risk) and boost long term returns by preserving capital in bear markets

Another key benefit of an active asset allocation strategy is the ability to change the asset allocation in various asset classes. Economics, politics, and the volatility of the market itself change the opportunities and risk of each asset allocation. Therefore it takes time and knowledge to properly research the investment climate and the different opportunities and risk involved with each. This style of portfolio takes much more work, as the research and opportunities are ongoing. We think it’s worth it.