Asset allocation, the practice of deliberately using several distinct forms of investments to accumulate or preserve wealth, has both obvious and subtle advantages. Various forms of investment include, but are not limited to, stocks, bonds, real estate, options, commodities, insurance, and currencies.
The Obvious Advantage
Most people readily grasp the obvious advantages of asset allocation. By spreading one’s wealth among a variety of investment types, one avoids “putting all of their eggs in one basket” and therefore reduces risk by reducing concentration. Sometimes stocks have bull runs and sometimes they have bear runs, sometimes bonds have solid returns, and other times they have low returns, and so diversifying between asset classes can reduce volatility and exposure to any particular risk. Fixed income investments have inflation risk, while equities are fairly resistant to inflation over the long-term. Equities are more volatile and have a more complex risk/reward profile.
The Subtle Advantage
Asset allocation is a bit more powerful than simply the obvious advantage. It allows one to, either actively or passively, take advantage of upturns and downturns in various asset classes.
Consider the simplified example of a portfolio perpetually consisting of 60% stocks and 40% bonds. Stocks and bonds tend to have imperfect inverse periods of highs and lows. In other words, when stock indices are going up, bond indices are often going down, and vice versa.
If one keeps their portfolio consistently allocated according to the 60/40 distribution, then they will be buying and selling stocks and bonds as the markets go up and down. When stock indices go up, the stock part of the portfolio will increase, and that would lead to the portfolio no longer being balanced with a 60/40 distribution. So, to counter that, some stock would have to be sold, and bonds purchased, in order to bring the distribution back to 60/40. Then, at a later time, when stocks have a considerable drop, the stock part of the portfolio will decrease, and that again would lead to the portfolio no longer being balanced with the 60/40 distribution. So, to counter that, some bonds would have to be sold, and stock purchased, in order to bring the distribution back to 60/40. A similar effect can be done by choosing to put regular contributions into whichever side is under-balanced.
If one keeps this up, they are essentially forcing their self to buy low and sell high. When stock indices are high, they are selling stock and buying bonds in order to get back to the 60/40 distribution. When stock indices are low, they are selling bonds and buying stock in order to get back to the 60/40 distribution. This approach, almost robotic-like in nature, allows one to buy low and sell high without attempting to predict market movements or time the perfect highs and lows.
This example can be expanded to include multiple asset classes. For instance, the “stock” category can be divided between domestic large caps, domestic small caps, and foreign stocks, and as their various indices go up and down, the wealth will be continually distributed among them.
Asset Allocation Doesn’t Necessitate Passivity
Many forms of asset allocation involve passive investments, but asset allocation should not be understood to necessarily mean a strictly passive investment strategy, although that’s one possibility. In fact, while I do not argue with the usefulness of index funds, I promote individual active investing in addition to them.
Why? In this particular article, I’m not going to get into the debate about whether passive or active investment is more likely to produce better returns for a given individual investor. Passive investing is an excellent financial strategy in many cases, and active investing may or may not produce better returns than this low-maintenance, high-reward strategy. Instead, the reasons I encourage individual stock selection are:
-The ramifications of citizens not having control of their country’s corporations are unfortunate in my view. With so much index investing and mutual fund investing, where people are invested in the economy as a whole with little concern for individual investments or shareholder voting rights, corporations are in a position to operate in a way that does a disservice to society. When the masses give up their voting rights into the hands of a few, rather than take active interest in the economy of their society, I find the situation to be problematic. What more could a board ask for than for shareholders to indirectly provide capital while willingly giving up their voting rights and attention?
-Some people panic or get confused when their passive retirement accounts decrease. There’s a sense of lack of control when people don’t understand their investments. Some people view the stock market as a casino, and some people take money out during market bottoms out of fear. When you’ve thoroughly analyzed a company, and can observe the specific results of their operations, the strength of their balance sheet, and their continued ability to pay and increase their dividend, then one becomes virtually immune to worry about stock price movements. One begins to only care about company performance. Disciplined passive investors can, however, achieve similarly powerful mindsets.
-Many people are unfortunately financially illiterate. I encourage people to be well-rounded: literate in science, history, business, culture, and so forth. Although not everyone is suited for active investing, the excuse that people are too busy doesn’t hold much water in my opinion.
-Although some forms of passive investing allow one to be a dividend investor, many of them do not. I feel that acquiring robust streams of passive income from investments that one understands is an important aspect of wealth, and many forms of passive investment don’t focus on it.
Regardless of whether you’re a passive or active investor, realize the obvious and subtle advantages of asset allocation, and use them to your advantage by understanding that asset allocation is more than just the sum of the parts. Keep your wealth growing and safe, and utilize approaches to buy at good prices without trying to predict market highs and lows.