Asset Allocation - What's That and Why Should We Care?

Finance research says that 90+% of portfolio return is attributable to asset allocation. Wikipedia has a useful entry on asset allocation that outlines some of the studies and issues. What does that mean in terms of what I should do as an investor?

The first step is to define terms. What is an asset? Almost every source skirts the issue and immediately begins discussing stocks and bonds as if the answer is self-evident. This makes me suspicious. Defining beauty as being in the eye of the beholder is fine for endeavours where judgement and qualitative judgements are acceptable but this is not the case in finance where fact-based reasoning is the basis for good decisions (though perhaps not the complete answer). One place that provides a definition of asset is Duke University finance prof Campbell Harvey's website. His definition is short and simple: "Any possession that has value in an exchange." The definition for exchange says that means places like the NYSE, NASDAQ, which trade stocks, bonds, commodities and indexes. In turn, therefore, the implication is that it is only those types of possessions that can be considered assets. Isn't this definition too restrictive? One enormously important possession which constitutes a considerable part of most individual investor's net worth, myself included, is my house. Many have cottages too. Then there are other kinds of possessions that many consider to be investments, such as fine art, antiques, coins, rare wines, even hockey memorabilia. At one time long ago, I believe tulip bulbs were a popular investment asset!

I suspect that such a restrictive definition, implicit in many investing tools, websites, books etc, where the choices discussed are limited to stocks and bonds, arises for a couple of reasons: first, availability of data that can be directly comparable and computed into portfolios in a risk-return relationship; second, the comfort zone and asset area familiarity of the advice giver, or maybe, to look at it more cynically, what the advice giver has to sell. Yet, out here in the real world, we individual investors deal with everything tangible and intangible that we can buy and sell. Such a broader definition of asset is provided by various sources such as Answers.com: "A resource having economic value that an individual, corporation or country owns or controls with the expectation that it will provide future benefit." In real life, we ask ourselves whether it is better financially to buy a cottage or invest in the stock market, so we need a financial structure to do that, recognizing of course, that not all such investment decisions are purely financial matters. The onus is on those who would exclude the broadest possible definition of asset.

I believe there is a critically important positive reason to factor in a broad range of assets and that has to do with risk reduction and diversification. Diversification only works in reducing risk if the various investments do not move in tandem. In technical terms, moving in tandem is expressed as a correlation coefficient, a statistical measure that moves between +1 and -1. At +1, two investments move exactly together all the time. There is no risk reduction at all from combining such assets. With 0 (zero) correlation, they do not move at all together but in random fashion relative to each other. The other extreme of -1 correlation is when one moves up, the other moves down. This is, in fact, the best situation since risk can almost entirely be eliminated. (It does not mean however, that there are no overall returns - that the negative return cancels out the positive and the investor is left with no net gain.) A very good explanation of how this works with simple examples to illustrate what I've just said is here at the website of TIAA-CREF.

So, the principle I draw from all the above is that assets and the choice of assets need to be defined functionally in terms of correlations amongst each other in anticipation of being combined into a portfolio with the highest return for the least risk. And to adopt a broad definition of portfolio, I think the appropriate definition is the combination of everything I own that can be sold, not just those pieces that sit in my brokerage account.

This isn't the end of the story on asset allocation. Next, for a future post, is the question of which assets have which type of correlation.