MBA Series – What Makes Asset Allocation So Important?
“Don’t put all of your eggs in one basket.”
The beginning of the year is typically portfolio rebalancing time for investors. I write a lot about investing as it is an achievable path to long-term wealth. If you don’t know what asset allocation is or much about investing at all, then this article is for you.
Modern Portfolio Theory is the science that drives most of the writing about investing today. After teaching a university Investments class, and reviewing the concepts of Modern Portfolio Theory, I’m reminded the key reasons that asset allocation is important.
What is Asset Allocation?
When creating an investment portfolio, asset allocation means selecting specific asset classes and choosing the percentage amount invested in each asset class. Sample asset classes are:
- U.S. Stocks
- U.S. Corporate Bonds
- International Stocks
- International Bonds
- Real Estate or REITs
- Government Bonds
- Small Cap Stocks
- Large Cap Stocks
Diversification – Tried and True Investing
Diversification in investing means don’t put all of your money in one investment or one type of investment.
Why diversify? There aren’t many people that can stomach three years of declining stock prices.
In 2000, the market dropped a total of a 42.85% during 2000 through 2002.
S&P 500
With a concentrated portfolio, when that investment goes down, there goes the value of your invested assets-down. And vice versa.
Buy different types of investments, so that when one goes down in price, the others may go up, or at least remain stable.
Diversification smooths out the ups and downs of your investments. For example, it is rare for bonds and stocks to go down drastically at the same time. During certain years, bonds will outperform stocks, and in others, stocks outperform bonds.
| S&P 500 Dividends Reinvested | US Small Cap | 3-month T. Bill | US T. Bond (10-year) | Baa Corporate Bond | Real Estate | Gold | |
| 2017 | 21.61% | 15.13% | 0.95% | 2.80% | 9.15% | 6.21% | 12.66% |
| 2018 | -4.23% | -16.21% | 1.97% | -0.02% | -3.18% | 4.52% | -0.93% |
| 2019 | 31.21% | 11.92% | 2.11% | 9.64% | 15.25% | 3.69% | 19.08% |
| 2020 | 18.02% | 34.16% | 0.36% | 11.33% | 10.60% | 10.43% | 24.17% |
| 2021 | 28.47% | 22.41% | 0.04% | -4.42% | 1.02% | 18.86% | -3.75% |
| 2022 | -18.04% | -22.90% | 2.09% | -17.83% | -15.23% | 5.65% | 0.55% |
| 2023 | 26.06% | 5.19% | 5.28% | 3.88% | 8.74% | 5.68% | 13.26% |
| 2024 | 24.88% | 8.70% | 5.18% | -1.64% | 1.74% | 3.96% | 25.96% |
| 2025 | 17.78% | 16.53% | 4.21% | 7.80% | 6.96% | 1.58% | 66.22% |
Source: https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html
Take a look at a 2022 anomaly: high inflation and subsequent interest rate spikes, caused a S&P 500 tumble of -18.04% and the 10-year US Treasury bond to plunge -17.83% simultaneously. However, look at how beautifully the balance restored itself just a year later: in 2023, the S&P 500 soared 26.06% while bonds stabilized with a return of 3.88%.
Despite the stock and bond market losses in 2022, your investment losses would have been tempered, had you also owned real estate and gold. Real estate delivered a 5.65% gain and Gold remained flat with a 0.55% uptick.
Over long periods, combining these asset classes drastically curtails your portfolio’s overall volatility.
Bonus: What Should My Asset Allocation Be?
Over long periods of time stocks have outperformed bonds, but a combination of diverse asset classes reduces your portfolio volatility (as measured by standard deviation). Notice that in 2021, the S&P 500, a proxy for the stock market averaged 28.40% return, while the 10 year Treasury bond lost 4.42%. Next, travel back in time to 2008 when the S&P 500 sunk a disastrous -36.55% and the 10 year Treasury bond enjoyed a 20.10% return.
With an all-stock portfolio, in 2016, you would have enjoyed an 11.74% return and a -36.55% decline in 2008. But, diversify a bit and the gain in 2016 wouldn’t have been as great, but neither would your losses have been as devastating in 2008.
Here’s Why Asset Allocation Is Important
Over the past 10 years, an all-stock portfolio would have earned an average 8.75% return, but with great volatility, as measured by the 18.74% standard deviation. Just think about how you might have felt in 2008 with a negative 36.55% return or in 2011 with a 2.10% stock market return while the 10 year Treasury bond advanced 16.04%.
Now, diversify with 70% of your money in stock market investments and 30% in bonds and over the past 10 years, you’d still have a respectable 7.63% return, but with a much tamer 10.87% standard deviation. Your worst return year would still be painful, at -19.56% in 2008, but certainly better than the -36.55% drop.
Bonus: How to Build an Investment Asset Management Strategy
Simple Portfolio Management for Successful Asset Allocation
The research abounds that a basic asset allocation of a certain percent in stock investments and a certain percent in bond investments has led to long term wealth creation.
As previously mentioned, there are all types of asset classes such as international stocks, country-specific stocks, small cap stocks, commodities, real estate, corporate bonds, government bonds, international bonds, sector ETFs and more. All of these types of assets can be bought as individual holdings, or combined in mutual funds and exchange-traded funds (ETFs). But, you don’t need to worry about the wide variety of asset classes unless you are passionate about investment management. You can obtain a satisfactory amount of diversification with just two ETFs or mutual funds.
For those DIY investors, seeking a simple two asset class investment portfolio, you’ll get sufficient diversification with part of your money in the Vanguard Total World Stock Index ETF (VT) and the remainder in the iShares Barclays Aggregate Bond Index ETF (AGG).
Index funds and ETFs are perfectly suited to a simple and effective portfolio management approach. A two asset portfolio might combines a world stock market index ETF with a total US bond fund. Depending on your age and risk tolerance, place more or less in each asset class.
With annual rebalancing to make sure the percentages in each asset class remain in alignment with your stated preference, you can grow your assets with little time spent in managing them. In other words, buy or sell from each holding to get back to the desired percentage amount invested in each fund. For a tutorial about How to Amass $787,355 with a Lazy Investment portfolio, click on the link.
For DIY investors, set a simple asset allocation to grow your wealth over time. There are even studies that suggest that a well-diversified asset allocation, rebalanced every year, will not only reduce volatility but increase your returns a small amount.
If you are not a DIY investor and want to pay a small fee for investment management, you might consider investing in a robo-advisor or target date fund.
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