Many articles, dissertations, and books have been written on this subject, far be it that we attempt to replicate this body of information and knowledge. Much of this body of work has evolved to become known as “Modern Portfolio Theory” with a multitude of mathematical formulas. We are always available to direct you to the multiple bodies of academic work that comprises this body of work as we do not believe it sensible to include this information in our brief outline and review.
This body of work has been instrumental in our understanding of conventional investment theory, but an additional comment we believe will help you understand its insufficiency. Greek letter math is absolutely critical to putting a man on the moon, but can lack precision when it comes to the management of one’s investment portfolio. Investing involves the inherent actions of human emotion. Mathematical formulas have not yet been able to compensate for the human aspects of fear and greed which move investors to extreme positions often times missing a reasonable target for expectations.
Asset allocations is simply diversification or do not put all your eggs in one basket. This concept has been around for approximately 2000 years.
Why is this important? Different asset classes move up and down in price and value at different times and in different magnitudes.
In its simplest format we refer to six primary asset classes. They are: cash, notes, bonds, stocks, real estate, and tangible assets. See the right side of the chart, Investment Seasons.
Since the 1960’s when the term asset allocation evolved into investment theory the subsets of the six primary asset classes has been incredible. To this the economic world has added multiple global markets as well as the additional subsets of investment styles. The creation of new vehicles to put money into seems to have no end in sight. For a expanded discussion of this concept see page 2 of Portfolio Design Compared to Portfolio Management.
A primary purpose for asset allocation is to provide a methodology for risk management. Again different asset classes have different risk properties and can move in different and even opposite directions. This can have the effect of managing//mitigating the overall risk profile of a portfolio. An issue with conventional asset allocation methodology is that it does not take into account the different investment seasons and the reality that asset classes can have extended periods of above or below average rates of return. (See; No Such Thing as Average). This in turn may affect your ability to generate a required rate of return. If interest rates are historically low as they have been after the 2008 financial crisis then your fixed income returns can be very low and your risk of principal losses on bonds can be higher.
As an additional part of our portfolio design process we recommend that you consider a Risk Class Profile and analysis to the individual securities that make up your asset allocation and investment portfolio. We have found this is helpful in portfolio design to stay within the Practical Limit of Risk.
Diversification and asset allocation do not insure a profit or protect against a loss. Investing involves risk and you may incur a profit or loss regardless of strategy selected.