First, you developed an Investor Profile. Step two in creating an Investment Policy Statement (IPS) is your target asset allocation.
How you intend to invest your capital.
As far as actual investing goes, this may be the most important piece of the puzzle.
What is Asset Allocation?
Asset allocation is the process investors use to distribute their investment capital between various asset classes within their portfolio.
The goal of asset allocation is to create a well diversified portfolio. That is, one which effectively reduces the overall portfolio risk while maintaining the expected level of returns.
Asset Allocation Options
Traditionally, capital is allocated between the three core asset classes: cash equivalents, fixed income (bonds and preferred shares), and equities. We have reviewed these core asset categories already.
Within these three core classes are many sub-classes. For example, within equities there are many options including sub-classes relating to: a company’s market capitalization; where they are located geographically; what industry they operate in. Within fixed income, sub-classes include: bond maturity date; credit quality of the issuer; currency.
Although there are three core classes to divide one’s capital, there are a myriad of choices within each category.
A growing number of investors are allocating a portion of wealth to other asset classes as well. Real estate, precious metals, venture capital, and derivatives, are a few such alternative asset classes. Part of the reason is increased investor understanding about the value of diversification. Part is due to the increasing quantity and quality of cost-effective investments in the non-core asset classes.
I think there are pros and cons to investing in alternative asset classes. But for the average investor, they are not a necessary inclusion in one’s portfolio. A few reasons why. But we will save that for later.
Diversification
When allocating funds between various investments, your goal is to effectively and efficiently diversify your portfolio.
We have previously covered diversification. I recommend you quickly review “An Introduction to Diversification” and “A Little More on Diversification”.
In brief, by adding different investments in your portfolio, you can reduce the overall portfolio risk while maintaining the weighted average expected return.
But effective diversification requires a little more than simply adding different investments to the portfolio. They need to be the right kind of investments.
You need to look at the correlation between assets to find the right type of investments.
Correlation is Key
The correlation between two assets tells how much they will move in tandem.
If they are perfectly positively correlated (correlation coefficient of +1.0), the prices of the assets will move together in lockstep. If they are perfectly negatively correlated (correlation coefficient of −1.0), their prices will move in opposite directions. And if they have no correlation (0.0), the two assets will move completely independently from each other.
Why is this the case?
Each asset class has its own unique risk and expected return profile. Asset classes react to stimuli such as changes in the economy, government monetary and fiscal policy, as well as other factors. Depending on the specific class, these factors will impact in different ways.
For example, consider interest rates. As interest rates rise, (non-real return) bond prices fall.
For successful diversification, investors want to spread out their assets so that the same factor does not affect all investments the same way. When one asset class is negatively impacted by a systematic risk, another asset class should benefit from that same factor.
This provides protection to your portfolio.
Yes, you will not fully participate in strong bull markets in any one asset class. But you also will not suffer the full brunt of any asset class specific bear markets.
If we look at asset classes, traditionally there has been a relatively low to (at times) negative correlation between equities and bonds. As bonds increase in value, stocks should perform relatively poorly. And as stocks rally, bond prices should suffer. By allocating capital between stocks and bonds, you protect yourself when either asset class is underperforming.
For an in-depth review of correlations, please read “Diversification and Asset Correlations” and “Asset Correlations in Action”. There is a lot of information and examples explaining the concept of correlations.
Lower the Correlation, Better the Diversification
In assessing the portfolio risk reduction impact that adding a specific asset will have to your portfolio, you must consider its correlation.
The lower the correlation, the higher its risk-reducing impact.
For example, the 2018 correlation between U.S. large cap and U.S. medium cap shares is about 0.90. Very close to perfect correlation of 1.0. The risk reduction benefit from diversifying in this case is poor. As large cap share prices increase, medium cap stocks will rise almost at the same pace. As large caps fall, so too shall medium cap shares.
However, if you allocate between a U.S. large cap and a U.S. bond fund, the 2018 correlation is approximately 0.20. The risk reduction by diversifying is substantial. Or, if you invest in U.S. real estate and emerging market equities, you will see a -0.67 correlation in 2018. Very nice for diversification.
Correlations Change
The level of correlation between specific assets is fluid to some degree.
Correlations can also shift over time in both directions.
For example, in 2011 the correlation between U.S. bonds and the S&P 500 was -0.31. Excellent for diversification. In 2018, that correlation had increased to 0.27. Still useful in building a portfolio, but less so than a few years ago. In 2025, perhaps the increase will continue. Or maybe it will reverse back to negative correlation. Hard to tell.
When conducting your periodic portfolio reviews, always check the correlation between your investments. If the correlations have shifted, determine why. It may be a temporary situation or perhaps it is significant and considered permanent. If the latter, you will need to reconsider your asset mix to ensure optimal diversification.
That is an overview on asset allocation.
We shall continue our look at asset allocation next time.
