Asset allocation is the cornerstone of successful investing, playing a pivotal role in balancing risk and reward in one's portfolio.  This strategy involves the distribution of assets across various classes—stocks, bonds, real estate, commodities, and cash—to align with individual financial goals, risk tolerance, and investment horizon.

My journey in asset allocation began at Russell Investments, a pivotal time when, as a young researcher, I cut my teeth modeling asset allocation strategies for pension funds. Those early years laid the foundation for my deep understanding of the intricate mechanics of the financial markets. It was here that I honed my skills in balancing risk and return, always with an eye towards long-term success.

Later, as a portfolio manager for one of the world's largest global asset managers, I steered the helm of global tactical asset allocation strategies. This role not only expanded my expertise but also offered me the unique opportunity to apply my theoretical knowledge in a practical, high-stakes environment

So why is asset allocation critical for your investment success? It's not merely about choosing between stocks, bonds, or cash. It's about orchestrating a harmonious portfolio that aligns with your risk tolerance, financial goals, and the dynamic nature of the markets.

At its core, asset allocation is about not putting all your eggs in one basket.

But it's more than just diversification. It's a methodical approach to selecting a mix of asset classes - such as stocks, bonds, and cash - that aligns with your financial objectives and risk appetite.

According to Ibbotson and Kaplan in their 2000 Financial Analyst Journal article, this strategic mix determines over 90% of your portfolio's return variability, making it more influential than the individual securities chosen.

Historical Perspective

Historically, asset allocation was a simpler affair. Traditional portfolios typically consisted of a mix of domestic stocks and bonds. However, as the financial landscape evolved, so did asset allocation strategies.

Today, investors can choose from a broader array of asset classes, including international equities, emerging markets, real estate, commodities, and more.

The Role of Risk Tolerance

Risk tolerance is central to asset allocation. It's not just about how much risk you can take; it's also about how much risk you need to take to achieve your financial goals.

For instance, if your goal is to save for retirement 10 years down the line, you might adopt a different strategy than if you're already retired and care more about generating income from your assets. Each goal requires a unique approach to balance risk and reward.

Dynamic and Adaptive

Asset allocation isn't a set-it-and-forget-it strategy. It requires ongoing adjustments. Market fluctuations, economic changes, and shifts in personal circumstances mean that your asset allocation should evolve.

Regular rebalancing ensures that your portfolio stays aligned with your goals and risk profile.

Evaluating the Allocation Mixes

In the dynamic world of investment, understanding and choosing the right asset allocation strategy is key to balancing risk and reward. Drawing inspiration from sophisticated institutional and large pension fund strategies, I have built three distinct approaches designed for various risk profiles – lower-risk, moderate-risk, and higher-risk.

These strategies, a blend of equities, bonds, alternatives, and cash, are crafted with a nod to the comprehensive and diversified portfolios managed by top-tier investors.

The three allocation strategies can be viewed as the middle component or “bucket” for people who use a time segmentation approach to building their retirement portfolios.

A “bucket” approach typically involves a short-term portfolio that covers living expenses for, say, three years, a middle bucket (like the three portfolios discussed here) that offers a blend of portfolio appreciation and inflation protection, and a third bucket that goes for high, long-term growth.

We’ll be covering the “bucket” approach in the future but if you want to find out more please go to Chapter 4 of my book, Reimagining Retirement - 9 Keys to True Wealth.

Let’s take a look at the three asset allocation strategies:

Lower-Risk Strategy: 

Inspired by the cautious yet strategic approach of institutional investors, this strategy focuses on stability and capital preservation, heavily featuring bonds. It integrates elements like international bonds and high-grade corporates, mirroring the risk-averse yet globally aware stance of large pension funds.

Moderate Risk Strategy: 

This balanced approach mirrors the diversified asset mix common in institutional portfolios. It includes a thoughtful blend of domestic and international equities, bonds, and real estate investments, offering a robust structure that seeks growth while maintaining a safety net.

Higher-Risk Strategy: 

For those aiming for growth akin to aggressive institutional funds, this strategy emphasizes a higher allocation in equities, including emerging market stocks, and alternatives like commodities. This mirrors the bold approaches of certain pension funds seeking higher returns through global market engagement and alternative investments.

Quick Explanation of Terms:

The long-term return and risk shown for each of the strategies are based on my long-term asset class expectations (more on this methodology later).

• The LT (long-term) return is based on the expected returns for each asset class weighted by the allocation percentages.

• The LT Vol (Volatility) is based on the assumed volatility and correlation amongst asset classes weighted by the allocation percentages.

• The Tracking number is the expected volatility of the strategy or tracking error as institutional investors call it relative to a mix of 60% US stocks and 40% US bonds.

• The Equity Risk number reflects how much of the prospective volatility of a strategy is driven by the equity allocation. For reference, the 60/40 mix has an equity risk of 87% based on my long-term assumptions. The reason is that equities are much more volatile than bonds. In general, equity risk dominates most portfolios.

Back to the Allocation Strategies:

Each strategy is more than just a plain vanilla domestic stock/bond mix. They are infused with the global perspective and diversified asset classes that hallmark large pension and institutional funds, tailored to fit individual investor risk profiles.

An investor could easily implement any of these three portfolios on their own by buying low-cost liquid ETFs in each of the major asset classes.

Beyond these three allocation strategies, I keep a close eye on four risk-based S&P strategies and a unique income-oriented approach by Morningstar. These packaged strategies are offered as single ETFs by iShares for investors looking for one-stop shopping.

This comprehensive monitoring allows me to assess and compare the risk and return profiles of various investment approaches, providing invaluable insights for smarter, more informed investment decisions.

When you look at the various weighting schemes they look quite different, but in reality many of the differences are more optical than real.

Higher risk is highly correlated with aggressiveness. Lower risk is highly correlated with conservatism. Over long periods, more aggressive strategies are expected to outperform but with a bumpier ride.

The key difference between the three strategies that we analyze in-depth and the S&P and Morningstar approaches boils down to our asset mixes having a higher proportion of international and alternative (real estate and commodities) assets to better resemble approaches used by large institutional investors.

Asset Allocation Strategy Performance

In the world of investing, the allure of 'hitting it big' can often overshadow the steady, assured progress of a well-diversified portfolio. Investors who bet everything on high-flying markets like the Nasdaq during boom times may temporarily appear as geniuses, enjoying the limelight of rapid gains. The stark contrast is seen during downturns, as evidenced in 2022, when both equity and bond markets suffered, leaving such investors in distress.

On the other hand, a diversified asset allocation strategy may not make headlines or be the subject of envy among those chasing quick riches. It's not the kind of portfolio that will be talked about for generations in the get-rich-quick circles.

Some Observations:

• Portfolios are still recovering from the 2022 capital markt collapse. You have to go back three years to be at or slightly above break-even. It’s the same way everytime after a market correction. You need to be patient and let the markets work for you.

• The 2022 collapse was unique in the sense that both stocks and bonds fell apart at the same time. The only asset class up in 2022 was Commodities.

• Last year proved very good for equity investors especially Large Cap US stocks. Bond allocations performed in line with long term expectations and cash investments provided a nice boost for the first time in a decade. You can thank the Fed for that!

• Thus far in 2024, and let me remind people not to infer a trend, only US Large Cap Equities and Commodities are in positive territory. All of the asset allocation strategies that we track have experienced small losses up to this point.

• It’s too early to tell if the outpeformance of US Large Cap Equities will continue. I doubt it based on market history. The more “love” an asset class is shown the more over-valued it’s likely to become. Valuations work at the extremes.

• It’s also too early to infer anything about the bond market. To a large extent what happens to monetary policy here in the US and abroad will shape the fixed income markets this year. Stay tuned!

• My sense is that capital markets are going to be fine in 2024. The long-held principles still apply. Diversification works over the long-term. Equities tend to historically perform better than bonds and bonds beat cash. Inflation is trending down (yet still a sore subject for many of us that did not appreciate the fiscal and monetary imprudence of our elected officials).

You can’t control the capital markets (or your spouse), but you do have control over your investment fees/expenses and the timing of your taxes.

In the long run, selecting an appropriate asset allocation strategy for your needs and comfort level while keeping your investment expenses as low as possible and avoiding the tax penalty of excessive trading gives you the best odds of meeting your financial goals while also sleeping better at night.

The strength of an asset allocation strategy lies in its stability and reliability. By spreading investments across various asset classes, including equities, bonds, alternatives, and cash, it cushions against market downturns and reduces the risk of catastrophic losses.

This approach may seem mundane during a market rally, but its true value shines in turbulent times. It's about playing the long game, prioritizing steady growth and selecting the risk profile that meets your needs and comfort level.

While an appropriatelly chosen asset allocation strategy may not provide the adrenaline rush of a market windfall, it offers something far more valuable - peace of mind and the increased likelihood of meeting your financial goals. After all, that’s why the money is there, right?

In future weeks I’ll be sharing additional perspectives and tools that will help you become a more informed and, hopefully, better investor of your capital.

Feel free to reach out to me at eweigel@retirewithpossibilities if you want to see a specific topic discussed, or have any observations to make this newsleteer a key part of your investment journey.

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