Asset Allocation Today

Asset Allocation, long thought of as a basic tenet of a good investment strategy, is not always every investor's friend. Controlling risk is important to most when markets are going down, not when they are going up. A good asset allocation model relies on the premise that a portfolio balanced between various asset classes will help control or mitigate investment risk.

In theory, this might be true. But in practice, many investors lack the discipline to make this a truism. The basic problem stems from the emotional disorder afflicting many investors, they buy and hold when the markets are good and sell when markets are bad. In other words they buy high and sell low.

To make asset allocation work, they would have to be willing to buy assets that no one wants, that are down in price, that look as if they will never recover. They would have to sell assets going up in price that everyone wants and that look like they are going to the moon. Not an easy bridge to cross!

The broadest and easiest form of asset allocation to understand is a model based upon equal parts stocks, bonds, and cash. Periodically the holder of this portfolio would sell a portion of the assets gaining value and buy that class going down in value. This requires faith that the asset classes will periodically cycle from low to high.

In strong up markets, this implies selling favorite stocks, for example, and buying low performing bonds. In 1999 or 2000 this concept would have resulted in most financial advisors losing their jobs, since getting a client to sell a prized asset that had just doubled or tripled in value in order to buy a bond earning 5% would have generated a rancorous argument.

If owning stocks is the only game in town as far as you are concerned, here are two additional ways to construct an asset allocation model. The first approach is to diversify by sector.

Ibbotson Associates ® publishes data periodically comparing annual returns for 10 major sectors: Materials, Utilities, Consumer Discretionary, Industries, Energy, Consumer Staples, Information Technology, Healthcare, Financials and Telecom Services. In 2002 they published a paper citing the benefits of sector asset allocation. According to Pen Chen, Ibbotson ® Vice President of Research, "Introducing industry sectors can enhance the risk-return tradeoff of a portfolio."

An investor building a portfolio around sector analysis would buy sectors that have bottomed and sell those that have topped out. Obviously the trick is to know which is which, and then have the discipline to buy low and sell high. For information on sector performance, Yahoo! ® Finance has an excellent chart with a variety of sector performance data.

A second asset allocation model focuses on investment style. Style refers to value versus growth, large cap vs. small cap, and domestic vs. international equities. Style analysis works well when reviewing performance of mutual fund managers where funds have a wide variety of holdings.

Stanford Professor and Nobel Prize winning economist William F. Sharpe pioneered returns-based style analysis. This allows investors the opportunity to evaluate portfolio managers by estimating a portfolio manager's style by determining the mix of passive benchmarks that best matched the actual returns of the fund.

This technique enables an analyst to develop a perspective about how the fund might behave in the future based upon historical performances. For more information on style analysis try www.styleanalysis.com.

Keith W. Springer, President of Capital Financial Advisory Services is a Registered Investment Advisor and a Mortgage Broker here in Natomas, located on the river at 1383 Garden Hwy. You can contact him at 916-925-8900 or keith@capfas.com