Unlike ”stock picking,” which is about selecting individual securities, asset allocation examines how the various categories of securities—stocks, bonds, alternative investments, etc.—perform as a group.
The result of a well-conceived asset allocation is a portfolio that achieves the required return at the lowest risk.
Why consider asset allocation?
A common approach amongst investors is to build a portfolio of ”winners.” The most important question is ”What stocks will generate the highest returns?” Following this strategy, an investor attempts to pick the next Apple or Tesla.
Besides being very difficult (even for experts), attempting to pick winners is not a prudent approach to investment. Asset allocation attempts to answer the question, “What combination of assets will help me achieve my objectives?” It requires consideration of three factors, specific to the investor:
Goals: These are a combination of short-term and long-term goals. These may include the provision of ongoing income after retirement, support for family members, and charitable causes. These goals translate into a required rate of return that the portfolio must deliver.
Risk tolerance: Investments carry different levels of risk. Investors also differ in their ability to endure declines in the value of their investment portfolio. An investor with a low tolerance for risk may be prone to make unwise decisions (such as selling at the bottom of a crash). Investors should remain with their risk tolerance.
Investment horizon: Investors may be well advised to accept greater risk when there is time for a portfolio to recover and there is no pressing need to make withdrawals. The investment horizon is often reflected in asset allocation. The shorter the horizon, in general, the less risky the portfolio.
Based on the above factors, we can proceed to develop a portfolio that meets the risk-and-return profile of the investors. Below are the principle tools of asset allocation.
Fundamental elements of asset allocation
Diversification
By building a portfolio of uncorrelated investments (i.e. investments that do not behave similarly), the gains in some investments in the portfolio tend to offset losses in others. This reduces the risk of the portfolio while preserving the return.
Risk management
Managing the risk of a portfolio is key to ensuring the sustainability of returns. We do this by identifying, measuring, monitoring, and hedging against the various forms of risk to which investments are exposed.
Rebalancing
Not all parts of a portfolio achieve their expected growth. Hence, an asset allocation may deviate from the original blueprint over time. Rebalancing corrects this natural drift and uses gains in well-performing assets to invest in attractively-priced opportunities.
Reinvestment
The power of compounding depends on the growth of the portfolio and the passage of time. Reinvesting income, such as dividends, is a straightforward, powerful way to increase growth and enhance the final value of a portfolio.
Asset protection
It is not possible to eradicate fraud or incompetence, but vigilance goes a long way to ensuring that your assets remain secure and available when you need them. Understanding issues such as custody, identity security, and who is charging you for what can prevent you beyond from many kinds of harm.
We’ll explore all of these five areas in more detail in separate articles in this section. Meanwhile, please consult your advisor or contact The Family Office for any questions or assistance.
About David M. Darst, CFA
Since January 2017, David M. Darst, CFA has served as Senior Advisor and Investment Strategist of The Family Office in New York and Bahrain. In this role, he has significantly contributed to the formulation, communication, execution, and monitoring of the company’s asset allocation, investment strategy, and wealth management activities in the Gulf region, North America, Europe, and Asia.
Following a 25-year career with Goldman Sachs in Zurich and New York, David served for 17 years as a Managing Director and Chief Investment Strategist of Morgan Stanley Wealth Management. David was the founding President of the Morgan Stanley Investment Group, and has served for three years as CEO of Petiole Asset Management AG, the Zurich-based asset management arm of The Family Office.
David is the author of sixteen books, including The Complete Bond Book (McGraw-Hill), The Handbook of the Bond and Money Markets (McGraw-Hill), The Art of Asset Allocation, Second Edition (McGraw-Hill) and The Little Book that Saves Your Assets (John Wiley & Sons), which has been ranked on the bestseller lists of The New York Times and Bloomberg Business Week.
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