Definitions of diversification and asset allocation strategies
Although the assumptions of modern portfolio theory are likely somewhat flawed, asset allocation using MPT is still a proven method to reduce volatility in an investment portfolio. A simple example using separate investors can help explain the value of diversification.
Our first investor, Investor A, has invested his entire portfolio in the shares of only one company. By comparison, Investor B’s portfolio B invested equally in the shares of 30 different companies. Investors risk that the entire stock market will decline and adversely affect their portfolios. However, Investor A also has risks associated with one company that owns its shares. If something specific happens to that company (i.e. profits disappointment, product recall, investor fraud, etc.), Investor A may lose a large portion of his investment. On the other hand, if this same scenario occurs for one of the thirty stocks in Investor B’s portfolio, it will not be devastating to the entire portfolio value. In the worst-case scenario, investor A could lose his investment entirely if the company goes out of business. Investor B will only lose 1/30 of its portfolio.
The previous example identifies two different types of risks associated with investing in financial markets. The first type of risk is the risk associated with the entire market or systemic risk. Regular risk affects all stocks in the entire market together, as a whole, and cannot be diversified away within that market. For example, if the entire US economy is weakening, it will affect all stocks within the S&P 500 to some extent. Diversifying your portfolio with other stocks within the S&P 500 will not reduce the overall risk in the portfolio significantly since other stocks share the same equity characteristics.
Another type of risk is the risk that is specifically related to individual security, or irregular risks. Asymmetric risks can be diversified easily, as seen in the previous example of diversification. If one invested equally among the shares of thirty different companies, and one of those companies went completely out of business, the loss in the total portfolio would be only 3.3%.
Asset allocation strategies
Asset allocation to portfolio management can be applied in different ways. Most asset allocation techniques fall into two distinct strategies – strategic asset allocation and tactical asset allocation.
Strategic asset allocation is a more traditional approach to asset allocation that uses the principles and assumptions of modern portfolio theory in a passive investment style. The goal of allocating strategic assets is to create a portfolio that is based on investment objectives and carries risks for the investor. Usually changes in the investment portfolio are made only when the portfolio becomes “unbalanced” due to market fluctuations, or the risk / return profile of the changes the investor requires, requiring an adjustment in the allocation.
Making changes to the portfolio when it becomes “unbalanced” is in line with the “value investing” philosophy that chooses investments because of its perceived lower value against an estimated substantial value. For example, if the allocation of international shares to the portfolio is less than the performance of allocating local shares, over time, the international allocation will form a smaller portion of the total portfolio, given that there are fewer unrealized gains that contribute to total investment in dollars. To reallocate the portfolio and return to the original asset mix ratios, one may need to sell some local shares and buy more international stocks. This is in line with the value investment, because you will buy unfavorable shares (perhaps undervalued) while selling the shares that are in favor (perhaps overvalued).
Tactical asset allocation is similar to strategic asset allocation, with some noteworthy differences. Like strategic asset allocation, the allocation of tactical assets depends on the assumptions of modern portfolio theory. However, unlike strategic asset allocation, it uses a more active investment approach that includes concepts of relative strength, sector rotation, and momentum. Rather than reallocating the portfolio when it becomes unbalanced due to market fluctuations, the allocation deliberately increases its weight in market sectors that outperform the market as a whole.
The strategy of allocating tactical assets differs from investing value in it. Instead of buying shares with poor performance, one buys or adds to positions that outperform the broad market. Therefore, in a tactically dedicated portfolio based on relative strength, one can largely concentrate in specific market segments. The idea behind this type of asset allocation is to remain somewhat diversified, but to focus more portfolio in areas of the economy that are improving. Research studies have shown that when one sector of the economy outperforms the market in general, there is a tendency for this sector to outperform for a long period of time.
The following graph shows the performance of the nine ETFs (representing the nine sectors of the S&P 500) compared to the performance of the S&P 500 over a period of one year. As can be seen from the graph, the three highest performing sectors are consumer goods, healthcare and utilities. The two worst performing sectors are basic materials and energy, where energy is the weakest sector. An investor can use this information by using a tactical asset allocation strategy to choose investments that outperform the broader market and avoid investments that are not performing well in the broader market.
Asset allocation limits
Even with all the benefits it provides, using asset allocation as a risk management strategy has limitations. Realizing these limitations will help investors understand when other tools can be used to reduce risk in their portfolios.
One of the main criticisms of asset allocation is that “black swan” events (unexpected events with catastrophic consequences) appear to occur more in financial markets statistically than if markets really follow the normal distribution. If true, the use of standard deviation as a measure of risk may be misleading, and the statistical correlation between asset classes may be distorted. Also, the correlation tends to increase between asset classes during the crisis period, making asset allocation less useful as a risk management strategy specifically when it is most needed.
Another criticism of asset allocation is that it does not inform the investor when to buy or sell the security. Buying and selling decisions are based on reallocating the portfolio (usually arbitrarily) when it appears that it needs to rebalance due to investor risk parameters, regardless of changing market conditions. Tactical asset allocation strategies can be used to address some of the timing of buying and selling decisions, which are not usually part of strategic investment decisions for asset allocation.
Finally, asset allocation as a risk management tool does not address the risk of portfolio withdrawal. Withdrawal is defined as the minimum value for an individual investment or investment portfolio reached after a previous peak in value. During secular bears’ markets, wallet withdrawals can be significant. Simply spreading a person’s investments across multiple asset classes may not provide adequate risk protection.