Asset allocation is a fundamental concept in investment strategy, yet it is often misunderstood.

Asset allocation involves determining the mix of investments across various asset classes, such as stocks, bonds, real assets, and cash, to balance risk and reward according to an investor's goals, risk tolerance, and investment horizon.

The primary goal of asset allocation is to optimize the risk-return profile of a portfolio by diversifying investments so that the performance of one asset class doesn't overly influence the portfolio's overall performance.

Many investors hold misconceptions about asset allocation that can hinder their financial success.

Let me debunk the top six asset allocation myths to help you make better investment decisions.

1. The More Assets or Investments, The Better (Fake Diversification)

One common misconception is that the more assets or investments you have, the better your portfolio will perform. This idea, often referred to as "fake diversification," can actually do more harm than good.

Diversification is about spreading risk, but simply having a large number of investments doesn't guarantee lower risk or better returns.

For example, owning multiple mutual funds that all invest in large-cap U.S. stocks isn't true diversification. If the U.S. stock market takes a hit, all your investments will likely suffer. True diversification means holding a variety of asset classes, such as stocks, bonds, real estate, and commodities, each of which behaves differently under various market conditions.

True diversification involves a mix of asset classes that respond differently to market conditions, reducing overall risk.

2. The Asset Allocation Mix Should Never Change

Another misconception is that once you've set your asset allocation, you can leave it unchanged. In reality, asset allocation should be dynamic, adjusting to changes in the market, your financial goals, and risk tolerance.

Expected returns, risk, and correlations between assets fluctuate over time. For instance, bonds might offer lower returns during periods of rising interest rates, prompting a shift toward equities or alternative investments. A dynamic asset allocation strategy involves regular reviews and adjustments, keeping your investments aligned with your financial objectives.

The concept of "guardrails" is useful here. Set target ranges for each asset class and rebalance your portfolio when allocations move outside these ranges. This ensures that your investment strategy remains proactive rather than reactive.

Your asset allocation should adapt to market changes and maintain alignment with your financial goals and risk profile.

3. Asset Allocation is All About Risk Management

While risk management is a key component of asset allocation, it's not the whole story. Effective asset allocation also balances risk with potential reward. The goal is to achieve the highest possible return for a given level of risk.

Consider the risk-reward trade-off: higher-risk assets like stocks generally offer higher returns, while lower-risk assets like bonds offer lower returns. A well-balanced portfolio should include a mix of both, tailored to your specific risk tolerance and financial goals.

Portfolios balancing risk and reward tend to perform better over the long term compared to those focusing solely on risk minimization or return potential.

Balancing risk and reward is crucial for long-term investment success

4. There is “One” Right Asset Allocation

Many believe there is a universal "right" asset allocation that fits everyone. However, the best asset allocation depends on individual circumstances, including your financial goals, time horizon, and risk tolerance.

For example, a 45-year-old saving for retirement will likely have a different asset allocation than a 70-year-old in retirement. The younger investor can afford to take on more risk with a higher allocation to equities, while the older investor might prioritize capital preservation with a higher allocation to bonds and annuities.

Personalization is key. What works for one person may not work for another, highlighting the importance of a tailored investment strategy.

Your asset allocation should be as unique as your financial goals and risk tolerance.

5. The Right Asset Allocation Strategy Would Never Lose Money

Some investors mistakenly believe that a well-diversified asset allocation strategy guarantees no losses. That is impossible. Diversification reduces risk, but it cannot eliminate it.

During market downturns, even a diversified portfolio can experience losses. The 2008 financial crisis, for example, saw declines across almost all asset classes. Most recently in 2022, we saw both equity and bond markets experience bear markets.

The goal of diversification is to mitigate the impact of such downturns, not to avoid them altogether.

Understanding this helps manage expectations and encourages a long-term perspective on investing.

Proper diversification mitigates risk but doesn't guarantee only gains.

6. Asset Allocation Explains 90% of Portfolio Returns

The seminal research paper by Brinson, Hood, and Beebower published in 1986 in the Financial Analyst Journal suggests that asset allocation explains about 90% of portfolio returns. However, this is a misinterpretation. The study actually indicates that asset allocation explains approximately 90% of the variability of returns, not the returns themselves.

This means asset allocation plays a crucial role in how much your portfolio's performance fluctuates, but it doesn't account for most of the returns.

A related paper published by the Financial Analyst Journal in 2001 authored by Ibbotson and Kaplan provided further context on the importance of asset allocation. They found that asset allocation explains most of the variability of portfolios but only about 40 to 50% of returns.

Asset allocation is very important, but investment selection, cost control, and tax minimization are also vital components of investment success.

For instance, choosing low-cost index funds over high-fee actively managed funds can significantly impact your returns over time. Similarly, employing tax-efficient investment strategies can enhance after-tax returns.

Asset allocation explains most of the volatility of your portfolio but only accounts for about ½ of its returns.

Many investors fall prey to common misconceptions that can significantly hinder their financial success.

Let’s recap and reinforce the key takeaways to ensure you avoid these pitfalls.

Proper asset allocation involves strategic diversification, dynamic adjustments, balancing risk and reward, personalizing your approach, and understanding the limitations of diversification.

Incorporating these principles into your investment strategy can lead to a more resilient and successful portfolio.

While asset allocation is vital, it’s just one piece of the puzzle.

Combine it with disciplined investment selection, vigilant cost control, and smart tax management to achieve your long-term financial goals.

The Big Picture:

• Equities keep outperforming bonds. 

• The dominance of US large-cap equities has been a key driver of the outperformance over the last decade.

• All major asset classes had positive returns last week.

• The big winner last week was Emerging Market Equities, up 3%. US Real Estate also had a good week for a change, up

• Cash is again outperforming bonds this year. Until there is more clarity as to the direction of Fed policy this situation is likely to persist.

• The investment environment remains risk-on. Aggressive asset allocation strategies continue their outperformance.

• Our Risk Aversion Index (RAI) remains in the Exuberant Zone.

Economy:

• US economic news is anchored on two issues: inflation and growth.

• On the inflation front, the news got marginally better this past week. The CPI showed a trialing 12-month inflation of 3.3%, slightly below expectations.

• On the growth front, the economy seems to showing some slackness on the employment side as well as some consumer caution in spending patterns.

• Retail sales were flat in April versus consensus estimates of a 0.4% gain. Luxury goods providers have seen a slowdown even among high earners.

Equities:

• US Small Cap equities dominated last week with the Russell 2000 up 1.8% while the S&P 500 was up 1.6%.

• Growth outperformed value once again.

• The best equity strategy over the last 5 years is US Large Cap Growth. The S&P 500 Growth Index is up 15.6% annualized.

• The biggest under-performer over the past 5 years has been Micro-Cap stocks.

• On the international front, the Chinese equity market continues its rebound. Last week the MSCI China Index was up over 4%. Year-to-date the market is up 15.6%.

• The Japanese equity market seems to have fallen into neutral territory as the Bank of Japan (BOJ) debates whether to rein in the falling yen and raise interest rates. Capital markets hate uncertainty.

Bonds:

• The Federal Reserve keeps hinting that a rate cut could come soon but in the same breath talks about needing to see lower inflation reports before it does anything.

• All of this talk is confusing the bond market with rates oscillating every other week.

• Year to date the performance of short-maturity bonds has trounced the return of long-maturity bond strategies. The iShares 20+ Year Treasury Bond ETF (TLT) is still down 6.3% for the year.

• Fixed income strategies with an equity kicker/exposure such as High Yield and Convertibles have outperformed this year.

• The widely followed US Aggregate Index (AGG) has a 30-day SEC yield of 4.73% with a duration of 6 years. Should rates drop, say 25 basis points, holders would show a 1.5% capital appreciation in the process erasing the year-to-date loss (currently at -1.05%).

• As long as the US economy remains healthy, the best risk/rewards are on the short end of the yield curve and credit exposure.

Signal Versus Noise

What’s Coming on Premium Wednesday😀 

• Asset Allocation Performance - Portfolio Implications

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