What is asset allocation?
Asset allocation is a strategy used by managers of some of the largest pools of money. This can be private wealth, pension funds, insurance funds, college endowment funds, foundation funds and others. The idea is that some markets will go up or down more than others in any given time period, so occasionally adjusting the amount of exposure to each market will reduce risk, while not missing out on the next big thing.
A simple example of this would be something like splitting the funds equally into stocks, bonds, and cash, then once a year re-balancing the portfolio back to equal amounts in each allocation. So what went up gets reduced and what went down gets added to. Over a period of years this should result in selling high and buying low while reducing total risk and volatility by not having everything in one basket.
A more sophisticated approach would be to add more sectors to the portfolio. This can include sectors like domestic and international stocks, bonds, cash, gold, real estate, commodities, and crude oil. Larger funds can further subdivide these sectors into sub-sectors. We will look at some of the ways to do this.
With stocks there are seemingly infinite choices of single stocks and stock funds. Diversification can be obtained simply by using an exchange traded fund (ETF) or mutual fund that follows a major index, such as the S&P 500, Dow Jones Industrial Average, or an index of a stock exchange in another country. Investing in foreign stocks introduces the factor of currency fluctuation. There is also stock sector investing. Our own 12 Points current market trends tables illustrate sectors.
There are many types of bonds; these have different durations to maturity, are issued by governments or private corporations, are domestic or foreign, and may be inflation indexed or fixed. They are also ranked by risk, with higher risk “junk bonds” normally offering higher yields. A diversified bond portfolio could include all of these. Keep in mind that foreign bonds include currency risk unless they are denominated in your own currency.
Cash is in a form that is immediately liquid and always reflects the value of the currency. Examples would be the cash balance in a brokerage account, a bank certificate of deposit, or short term (3 to 6 month maturity) government bonds.
Central bankers usually keep a portion of their monetary reserves in some form of gold. Gold in bullion form (bars and coins) held by the owner represents an asset that is not a liability of a counter party, so it is considered the asset to hold against risk of default on other assets. Almost all other investments, including cash, depend in some way on the performance and ability to pay of another party, whether governmental, corporate, or individual. Additionally, gold tends to rise during periods of economic uncertainty, so as a sector investment it can give a hedge against other losses.
How to diversify with real estate depends on portfolio size. The small investor can simply use Real Estate Investment Trusts (REITs) on a stock exchange. There is a wide variety of REITs, foreign and domestic investing in various types of real estate properties. Larger funds can purchase real estate directly, usually in the form of apartment buildings, commercial buildings, or farm land.
Commodities are the raw materials of life. Price fluctuations of various commodities can be used to the benefit of a diverse portfolio. Small investors can use ETFs. There are diversified commodity ETFs as well as single commodity ETFs. Institutions and large funds are more likely to purchase futures contracts without using margin for diversification. See our article on Commodity ETFs.
Crude oil is the most widely traded commodity. It is also used in producing and moving all other commodities, so it can be the proxy for commodity investments in a diverse portfolio without getting involved in other commodities. For smaller portfolios there are ETFs such as USO and USL that are based on crude oil futures contracts. Larger portfolios can trade without margin by directly purchasing crude oil futures contracts on a cash basis. Futures are less attractive in high interest rate environments due to carrying costs and lost opportunities for higher yields on safer investments.
Final thoughts on asset allocation
Asset allocation can take many forms, but it is used in some way by most of the largest and most successful funds.
Periodic re-balancing is something that can result in less long term risk while taking advantage of unequal performance of sectors over time.
One factor to keep in mind when choosing when to re-balance a portfolio is that it can pay to consider tax implications of short term versus long term capital gains. This is a factor in favor of holding investments for one year or longer for those in higher tax brackets.