In the field of investing, asset allocation stands as a cornerstone of success, a strategy so pivotal that its impact can make or break an investor's long-term returns.

Yet, a pervasive myth haunts the personal finance world: the belief in a magical, one-size-fits-all formula for allocating assets.

The truth is, that asset allocation is as personal as a tailored suit. It should fit an investor's financial situation, goals, and risk tolerance with precision. Ignoring this customization leads to common missteps that can derail financial aspirations.

From assuming a universal strategy works for everyone to neglecting the importance of an adaptable, informed approach, DIY investors often find themselves navigating turbulent financial waters without a compass.

This note aims to arm you with the knowledge to avoid these pitfalls, drawing on insights from years of managing asset allocation portfolios across a spectrum of market environments and client types. By understanding these common mistakes and learning how to sidestep them, you can lay the foundation for a more secure and prosperous financial future.

Mistake #1: Failing to Pay Attention to Investor Risk Capacity

While many investors understand the concept of risk tolerance—how much volatility they can emotionally withstand—they often overlook risk capacity, which is arguably even more critical.

Risk capacity refers to an investor's financial ability to endure losses without affecting their long-term goals. This oversight can lead to asset allocation strategies that are not in line with one's actual ability to absorb financial shocks, leading to potentially dire consequences.

The Financial Implications of Ignoring Risk Capacity

Risk capacity is determined by tangible financial factors, including your investment time horizon, income stability, existing financial resources, liquidity needs, and financial obligations.

An investor close to retirement, for example, has a significantly lower risk capacity than someone just starting their career. Despite this, the allure of high returns can tempt investors to skew their portfolios towards high-risk assets, underestimating the potential for loss and the time required to recover from market downturns.

Assessing Your True Risk Capacity

To accurately assess risk capacity, investors need to conduct a thorough financial analysis, considering:

• Investment Time Horizon: The length of time you plan to hold investments before needing to access your capital.

• Financial Obligations: Current and future liabilities that could impact your ability to absorb losses.

• Existing Financial Resources: The greater your resources in relation to your lifestyle needs the more risk you’re able to bear.

• Income Stability: How secure is your source of income? Could you continue to meet investment and living expenses if your income were disrupted?

A couple of weeks ago I wrote about this concept. Here’s a diagram to help you assess how aggressive you should be in terms of your asset allocation mix.

Once you have a clear understanding of your risk capacity, adjust your asset allocation to reflect this.

• For those with a lower risk capacity, this might mean prioritizing investments in more stable asset classes, such as bonds or high-quality dividend stocks, which can offer more predictable returns and lower volatility.

• If you have a high-risk capacity, you might allocate a larger portion of your portfolio to growth-oriented investments, such as growth stocks and private equity, which carry higher risk but offer the potential for higher returns over the long term.

Mistake #2: Never Adjusting the Asset Mix to Reflect Changing Asset Volatilities and Correlations

A common oversight among investors is the failure to adjust their asset allocation in response to changes in market conditions.

Asset classes do not move in isolation; their volatilities and correlations to each other change over time due to economic shifts, policy changes, and global events. Sticking to a static asset allocation without considering these changes can expose investors to unintended risks and missed opportunities.

Understanding the concepts of volatility and correlation is crucial for effective asset allocation.

Volatility measures how much the price of an asset fluctuates, while correlation indicates the degree to which two assets move in relation to each other. By analyzing these factors, investors can craft a portfolio that aims to optimize returns for a given level of risk.

The Dynamic Nature of Markets

Financial markets are inherently dynamic, with asset volatilities and correlations fluctuating based on a myriad of factors. For example, during extended bear equity markets we expect the correlation between stocks and bonds to decrease, making bonds an effective diversifier. Conversely, in bull markets, we might see an increased correlation between equity asset classes such as large and small-cap stocks, reducing the effectiveness of diversification.

While strategic asset allocation lays the groundwork for long-term investment objectives, tactical adjustments can enhance returns and mitigate risks in the short to medium term. This might involve temporarily increasing the allocation to defensive assets when equity markets appear vulnerable or taking advantage of growth opportunities after periods of capital market stress.

Tactical adjustments should not be based on gut feeling but on a comprehensive understanding of market fundamentals. Overreacting to market volatility can be just as harmful as ignoring it entirely.

By staying informed and flexible, investors can adjust their asset allocation to better reflect the current market environment. This proactive approach can help navigate the complexities of investing, ensuring that your portfolio is positioned to capitalize on opportunities while managing risk effectively.

Mistake #3: Not Understanding How Diversification Works

A common misconception among individual investors is expecting all investments to perform well simultaneously. This misunderstanding of diversification's role can lead to disappointment when parts of a well-diversified portfolio underperform. More critically, some investors expect diversification to provide immediate protection against market downturns, misunderstanding its long-term purpose.

Diversification is the investment strategy of spreading your investments across various asset classes to reduce risk. The idea is not to maximize returns in every component of your portfolio at once but to mitigate the impact of any single investment's poor performance on your overall portfolio.

Unrealistic Expectations

Expecting all diversified investments to rise together is a fundamental misunderstanding. Different asset classes can react differently to the same economic events. For example, while stocks may decline during an economic downturn, bonds or other fixed-income investments may hold steady or even increase in value, thereby cushioning the portfolio against significant losses.

The benefits of diversification are most evident over the intermediate term. In the short term, market volatility can affect all asset classes, sometimes simultaneously. However, over longer periods, a diversified portfolio tends to have a smoother return trajectory than any of its components.

This smoothing effect is the real value of diversification, not the elimination of risk or guarantee of returns.

Understanding the correlation between different assets is key to effective diversification. Assets with low or negative correlations to each other can provide a more robust defense against volatility. However, correlations can change over time, necessitating ongoing monitoring and adjustment of your asset allocation.

Common Diversification Pitfalls

• Over-diversification: Spreading investments too thinly across too many assets can dilute potential returns without significantly adding to risk reduction.

• Under-diversification: Holding too few investments or overly concentrating in similar assets or sectors can expose you to heightened risk.

Diversification is a fundamental investment principle designed to manage risk, not eliminate it. By properly understanding and applying diversification, DIY investors can improve their chances of achieving stable, long-term investment returns.

Remember, the goal of diversification is not to boost performance in the short term but to create a balanced portfolio that can withstand various market conditions over time.

Mistake #4: Making the Asset Allocation Decision Solely Based on Views on Equities

Many investors place undue emphasis on the equity markets when making asset allocation decisions, often to the detriment of a balanced and diversified portfolio.

This mistake can lead to a disproportionate allocation to stocks or stock-based investments, disregarding the critical roles that bonds, commodities, real estate, and cash equivalents play in a well-rounded investment strategy.

Equities, while potentially offering higher returns, come with higher volatility and risk. Investors attracted by the allure of stock market gains may overlook the stabilizing presence that other asset classes can provide, especially during periods of market turbulence.

Understanding the Role of Other Asset Classes

• Bonds: Offer regular income and tend to be less volatile than stocks, serving as a counterbalance to equity risks.

• Commodities: Can act as a hedge against inflation and provide diversification benefits due to their low correlation with stocks and bonds.

• Real Estate: Provides potential income through rent, along with appreciation benefits, and adds another layer of diversification.

• Cash and Cash Equivalents: Offer liquidity and safety, crucial during market downturns or for taking advantage of new investment opportunities.

Strategic asset allocation involves setting a baseline allocation among different asset classes that align with your investment goals, time horizon, and risk tolerance. This strategy recognizes that each asset class has its own risk and return profile and contributes uniquely to the portfolio's overall performance.

Focusing too narrowly on equities when making asset allocation decisions can expose DIY investors to unnecessary risks. 

A well-considered asset allocation strategy that includes a mix of stocks, bonds, commodities, real estate, and cash can provide a more stable and potentially more profitable investment experience over the long term.

Understanding the unique attributes and roles of different asset classes is essential for building a portfolio capable of navigating the complexities of the financial markets.

Mistake #5: Failing to Take Into Account Current Starting Valuations for Each Asset Class

One of the subtler, yet critical, aspects of asset allocation that DIY investors often overlook is the impact of current starting valuations on future returns.

Valuations play a crucial role in determining the potential risk and return of different asset classes over time. Ignoring valuations, particularly in the context of historical norms, can lead to misinformed asset allocation decisions and suboptimal investment outcomes.

Valuations give investors a snapshot of an asset's current price relative to its underlying fundamentals, such as earnings, assets, or expected growth.

For example, equities with high price-to-earnings (P/E) ratios may suggest overvaluation, implying limited upside potential and higher risk. Conversely, assets trading below their historical valuation norms may offer more attractive risk-reward profiles.

Valuations Across Asset Classes

• Equities: High valuations often signal caution, as future returns may be lower when starting valuations are elevated.

• Bonds: The yield at the time of purchase significantly influences bond returns. Bonds bought at low yields may offer less income potential and more exposure to interest rate risk.

• Real Estate: Cap rates and price-to-rent ratios can indicate whether real estate investments are priced attractively compared to historical averages.

• Commodities: Prices relative to production costs and historical ranges can provide insights into potential commodity market movements.

Failing to consider valuations can lead to investing in overpriced assets with a poor risk-return profile. During periods of market exuberance, it's easy to get caught up in the momentum and overlook whether current prices are justified by fundamentals.

History has repeatedly shown that investments made at high valuations tend to have lower future returns.

Incorporating valuations into the asset allocation process involves a disciplined approach to evaluating and comparing the current price levels of different assets. Our approach honed over many years managing institutional assets relies on both relative as well as absolute valuations.

• Relative Valuation: Comparing the valuations of various asset classes to identify those that appear more or less attractive.

• Absolute Valuation: Assessing whether an asset class is priced favorably relative to its own historical valuations.

Other fundamentals that we consider in addition to valuations are expected growth rates and income generation potential. The goal is to create a mapping of all key asset classes that creates as close as possible an apples-to-apples comparison.

By integrating current starting valuations into the asset allocation process, investors can make more informed decisions that better align with their investment goals and risk profile. Recognizing the significance of valuations and adjusting asset allocations accordingly can enhance the potential for favorable long-term investment outcomes.

Mistake #6: Not Having a Contingency Plan for When Things Go Wrong (and Right)

A common oversight among investors is the absence of a contingency plan for their investments.

Investment strategies often focus on the best-case scenarios, neglecting to prepare for market downturns or even unexpected upswings.

This lack of preparedness can lead to reactive decision-making in times of market stress or missed opportunities during positive market trends.

In the institutional investment world, this preparedness is often encapsulated in the concept of having minimum and maximum bands for asset allocations, ensuring disciplined responses to market movements.

The Role of Contingency Planning in Investment Strategy

Contingency planning in investment involves establishing predefined actions or criteria for adjusting your portfolio in response to significant market changes.

This plan should address both adverse scenarios, such as market crashes or economic downturns, and positive developments, like unexpected bull markets.

Minimum and maximum bands set the boundaries within which your investments can fluctuate before necessitating a rebalance.

For example, if you've determined that your portfolio should hold 60% equities but set a minimum band at 55% and a maximum band at 65%, a market movement causing your equity allocation to fall outside these bands would trigger a rebalance.

A solid contingency plan for downturns includes strategies for liquidity management, such as maintaining a cash reserve and identifying potential assets for rebalancing or hedging against further declines.

Conversely, in times of market upswings, your contingency plan might involve taking profits from overperforming assets and reinvesting in underperforming or undervalued assets. This proactive approach can help lock in gains and maintain a balanced portfolio aligned with your long-term investment goals.

Having a contingency plan provides psychological benefits, instilling confidence and reducing the temptation to make impulsive decisions based on short-term market movements.

Knowing you have a strategy to manage various market conditions can provide peace of mind and help you stay focused on your long-term objectives.

By incorporating minimum and maximum bands into your investment strategy and preparing for both challenges and opportunities, you can create a more resilient and adaptable approach to achieving your financial goals.

The absence of a contingency plan can leave investors vulnerable to market volatility and uncertain about how to respond to changing conditions.

This disciplined planning enhances decision-making, helps manage emotional responses to market movements, and ultimately contributes to a more successful investment journey.

Understanding and avoiding the most common asset allocation mistakes can significantly enhance your chances of achieving long-term financial success.

From recognizing the personalized nature of risk appetite and capacity to the dynamic adjustments required in response to market volatilities and correlations, each mistake highlighted offers a lesson in the complexities of effective portfolio management.

Asset allocation is not a set-and-forget strategy.

It demands ongoing engagement, reflection, and adaptation to your evolving financial landscape, investment goals, and the external economic environment.

The six common mistakes discussed serve as a roadmap for navigating the ever-changing waters of personal investing:

By addressing these areas with insight and discipline, you can build a robust investment strategy that not only withstands the test of time but also aligns with your financial aspirations.

The goal of investing is not to outperform the market at every turn, but to construct a portfolio that grows with you, supporting your financial needs.

Asset Allocation Performance Review

High-Level Observations:

• Conservative portfolios with a heavier allocation to bonds are still recovering from the 2022 capital market collapse. Over the last three years, the GF Low-Risk strategy is only up 1.2% on an annualized basis (before fees and transaction costs) while the S&P Conservative portfolio shows a 0.2% annual loss.

• Equity-heavy allocations have outperformed more conservative allocations thanks largely to the performance of US large-cap equities. The GF High-Risk strategy is up 2.9% on an annualized pre-cost basis over the last three years while the S&P Growth portfolio is up 2.3%.

• The last week has not been kind to investors in US equities. Both large and small caps have hurt performance while bonds continue to languish, especially on the long end of the yield curve.

• In the US as well as in international markets, growth has underperformed value in the last week. Some of this reversal was expected given the wide disparity in performance over the last year. Most of the underperformance was due to Tech and Telecom Services.

• On a positive note, Emerging Market Equities continue their rebound from very depressed levels. The stimulus measures by Chinese authorities have improved sentiment but we’re still a bit cautious about how long equities can be propped up in the face of a real estate bust and a slowing economy. Remember that Chinese equities represent about 1/3 of the MSCI EM index.

• Similarly, International Developed Equities (EAFE) have shown some life with the MSCI Japan Index up 2.8% in the last week. Year-to-date Japanese Equities are the best-performing major market, up 5.8% in US dollars. On a local currency basis, the performance of Japanese equities has been even more impressive given the depreciation of the Yen.

Weekly Performance Attribution

Source: iShares, as of 2/20/2024

A Bit of Humor Never Hurts

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