Understanding Asset Allocation

You have probably heard the old adage about not keeping all your eggs in one basket. Asset Allocation is the application of that bit of folk wisdom to managing your investment portfolio. Just as having all your eggs in one basket creates the risk of them all being broken by some event, having all your wealth invested in one asset or class of assets creates the risk that some event can wipe out all your investments at one fell swoop.

We can manage this risk by diversifying our investments into different asset classes such as shares, bonds, cash, property and commodities. When we combine these assets in a portfolio we reduce the level of risk without reducing to the same degree the return. The basic idea being that in any given market situation each asset class will react differently. For example an interest rate rise caused by inflation could be negative for bonds but positive for cash and commodities.

We measure the relationship between them by looking at the correlation between these different asset classes. For example you would find a higher correlation in terms of price movement between different types of equity than you would with bonds and commodities when reacting to changes in the economy. You would also find a stronger correlation between property and commodities than equity or cash if that economic event was something like inflation.

To manage what is the best mix of assets we use something called Modern Portfolio Theory. It is an idea that was first proposed by American Economist Harry Markowitz in a 1952 paper that later won him a noble prize. The theory uses mean-variance analysis to construct a portfolio of assets so that the expected rate of return is maximized for a given level of risk. Its main difference from just assessing the risk of individual assets however is that is uses the correlation between various asset classes within the portfolio to create an "efficient frontier" on which you will get the best rates of return for a given level of safety.

It does however have its limitations. It looks at the correlation of assets as a mathematical relationship and not as a systemic one. We saw in the 2007 Financial Crisis that Black Swan events can cascade through a financial system in ways that the algorithm can not foresee and that at the extremes, correlations exist that historical data do not expose. It is also at odds with Value Investment Strategies since it relies on the efficient market hypothesis which states that all assets are correctly priced at all times by the market. Contrarian/Value investors look for inefficiencies and biases in the market that create opportunities to buy under priced assets.

Despite its limitations Modern Portfolio Theory is still at the core of most asset allocation models and should be the starting point for constructing any investment portfolio where the objective is long term growth. It can be combined with other strategies in a core and satellite strategy that lets you take advantage of opportunities created by technology, events or cyclicality in the market to enhance the rate of return while at the same time keeping the whole portfolio within an acceptable levels of risk.