Understanding Asset Allocation and Portfolio Diversification
17 MIN READ
As an immigrant, investing in the United States stock and bond markets can seem overwhelming. There is so much to learn and you may feel like you’ll never be able to get started. Asset allocation and portfolio diversification are two of the most important investing terms to know when you’re putting together your financial plan. You’ll need to be able to define each and determine how they fit into your life.
However, you may need some help from a financial planner when you’re first starting your investing journey. At MYRA, our goal is to help you get control of your finances and make a plan for the future. We’ll help you understand how financial planners use asset allocation and diversification to set their client’s up for success.
The article discusses what asset allocation is, and the importance of it in a portfolio. The article also talks about diversification, and how it may help achieve better returns in a portfolio. In addition, the article discusses other topics such as the Portfolio Theory, Capital Asset Pricing Model, Arbitrage Pricing Theory, The Efficient Market Hypothesis, Security Market Indexes and Averages, and Security Markets.
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Asset allocation is the process of distributing investment assets among various classes which can include money market securities, fixed income securities, common stock, international investments, real estate, or collectibles. Around 90% of long term portfolio performance is determined by the asset allocation of a portfolio.
The objective of asset allocation is to determine which investment categories will be used and the appropriate percentages for each asset class. Asset allocation models can have different strategies but must take into account your risk tolerance, time horizon, level of sophistication with regards to investment alternatives, the required rate of return to meet your objectives, and your financial and tax situation.
Strategic Asset Allocation
Strategic asset allocation is an allocation that has a purpose to choose an appropriate asset allocation based on the forecast of the economy, the expectations of selected asset classes, and your risk tolerance. When the factors are all considered, the asset allocation is chosen for the long run strategic mix. The mix will remain the same until another analysis is conducted.
Due to each asset class having different performances, rebalancing has to take place in order to bring the portfolio back to the strategic mix. Rebalancing typically occurs twice a year. Rebalancing more than twice per year can incur additional transaction costs that outweigh any resulting benefit. Rebalancing is done to bring the distribution of assets back to the original model, or it can also be done to establish a new allocation model.
Risk Tolerance vs. Life Cycle
A client's risk tolerance has to be assessed to be concurrent with the client's financial life cycle. Clients who are younger can typically tolerate more risk than those that are older. Not only that, but specific asset classes must be included in the analysis.
For some planners, asset classes may be limited to only stocks, bonds, and cash. For others, 10 or more asset classes can be considered. For each asset class that is included in the analysis, the planner has to take into account the expected return, expected standard deviation, and correlation with other asset classes. Based on the client’s risk tolerance, an appropriate strategic mix can be chosen.
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Tactical Asset Allocation
Tactical asset allocation is defined as changing a mix of investment classes based on the changing market conditions. It can be referred to as market timing and is based on the belief that investors can increase returns over time by switching among asset classes.
Market timers analyze the different asset classes and determine which asset classes are under or overvalued. Securities in the overvalued asset classes are sold, and securities in undervalued are purchased with the anticipation that their prices will rise. Tactical asset allocation can have high transaction and turnover costs from constantly changing the mix between asset classes.
Core and Satellite Investment Strategy
A core and satellite is an investment strategy that invests in broad market indexes and higher-risk alternatives.
Core investments include U.S stocks, U.S. fixed-income, and developed international equities. These investments usually track a major market index and use a passive investment philosophy to achieve market-based returns.
On the other hand, satellite investments include REITs, emerging markets, and high-yield bonds. The strategy attempts to achieve above-market returns by using high risk and global exposure.
Investors can choose to implement a core and satellite strategy through a portfolio of mutual funds. The goal of this strategy is to reduce portfolio risk through diversification, generating higher returns, minimizing costs, and managing taxes.
Practical Applications of Asset Allocation
The purpose of investment planning is to build an investment portfolio that is capable of accomplishing the financial goals of the client while matching the level of risk in the portfolio to the investor’s risk tolerance.
Many financial planners who provide investment counseling will use some type of mean-variance optimization software to determine an optimum asset allocation model based on the client’s goals, risk tolerance, time horizon, tax situation, and economic forecasts. The goal of the software is to build an efficient portfolio for the client. An efficient portfolio is one that has the highest level of return for a given level of risk.
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In 1952, Harry Markowitz developed the first foundation of the modern portfolio theory (MPT) by using the following assumptions:
- Investors consider each investment opportunity as being represented by a probability distribution of expected returns over a specified holding period
- Investors estimate the risk of the portfolio based on the variability of returns
- Investors base their decisions solely on the expected return and risk. Therefore, their indifference curves are a function of expected return and the expected variance of returns.
- Investors base their indifference from alternative investments on the maximization of wealth over a specified period. The indifference decreases as they get beyond this period
- For a given level of risk, investors prefer higher returns to lower returns
MPT is based on using statistical measures that include mathematical concepts such as beta and correlation. Many investments are required to diversify effectively, and that number depends on the correlation between the investments.
MPT uses risk and expected return as the basis for determining an efficient combination of assets. These combinations of assets can be called portfolios, and the spectrum of portfolios on the risk-return scale that is created is what is known as the efficient frontier.
Any portfolio that lies on the efficient frontier has either a higher rate of return for an equal risk or lower risk for an equal rate of return than another portfolio below or underneath the frontier. Portfolios can exist below the efficient frontier, but cannot exist above the efficient frontier.
The efficient frontier consists of the most efficient portfolios with the highest expected return for a given level of risk. Any portfolio that is above the efficient frontier is unattainable. Afterward, an indifference curve is used. Indifference curves that curve upward are used to measure the risk and reward trade-offs that investors are willing to take. The indifference curve will cross the efficient frontier in two locations unless the curve is tangent to the efficient frontier.
Investors have an infinite number of indifference curves to choose from. Using indifference curves along with the efficient frontier allows an investor to choose a portfolio that is suitable with the given level of risk.
The portfolio that lies at the tangent of the indifference curve and the efficient frontier is the optimal portfolio for the investor. The efficient frontier consists of portfolios with the highest expected return for a given level of risk.
An investor has to always follow these rules in order to choose efficient assets:
- For any two risky assets with the same expected return, choose the one with the lower risk
- For two assets with the same risk, choose the one with a higher expected return
- Choose any asset that has a higher expected return, but with a lower risk
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Capital Asset Pricing Model
The capital asset pricing model (CAPM) is developed largely by William F. Sharpe. It relied and expanded on the concepts that were developed by Harry Markowitz. The expected rate of return that is generated by the CAPM can be compared to the investor’s required rate of return in order to determine whether the investor should purchase or sell an investment.
In this model, there are several assumptions that are used in order to develop the model:
- All informed investors have a uniform expectation about the risk-return relationship of the risky assets
- Investors can borrow and lend at a specific positive risk-free rate of return
- Transaction costs are zero
- Taxes are zero
- At all times, capital markets are in equilibrium, this establishes a baseline to evaluate the suitability of any investment
By using those assumptions, Sharpe identified a portfolio on the efficient frontier that would be considered the market portfolio. This is a portfolio that consists of all risky assets. A line can be drawn from the risk-free rate of return (y-axis) through the market portfolio, and that line becomes the new efficient frontier that consists of a combination of the market portfolio and the risk-free asset. The new efficient frontier is called the Capital Market Line (CML).
The CML also uses standard deviation as a risk measure. The CML is a representation of the relationship between the risk and for efficient portfolios. The CML is a broad or macro perspective of the risk and returns relationship.
Others such as the Security Market line has the versatility to be used with portfolios and individual securities. The SML portrays the risk-return relationship for efficient portfolios of securities, except it uses beta as a risk measure. The SML can also be used to compare actual results to expected results on a risk-adjusted basis.
Arbitrage Pricing Theory
The arbitrage pricing theory (APT) attempts to explain the return in terms of multiple factors. The CAPM explains the returns on a stock as a result of only one factor.
APT believes that returns for securities are based on different factors that can affect different groups of investments. Some factors can affect all securities, and others may only affect a specific industry. Certain factors such as accidents may only affect a single company.
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The Efficient Market Hypothesis
The efficient market theory suggests that investors are unable to outperform the market on a consistent basis without taking on additional risk. The theory assumes that the current stock prices reflect all available information for a company that the prices rapidly adjust to reflect any new information.
Due to the market being efficient in valuing securities very quick and accurate, investors are not able to find undervalued stocks consistently. The day-to-day price changes in a random walk pattern. The pattern occurs because future events cannot be predicted from past information. The current stock prices reflect all the current known information.
Therefore, stock prices can change at random, and if the prices move in a random fashion, any trading rules or techniques will be useless. New information must be unexpected otherwise it would be reflected in the current stock price. If new information is unexpected and random, the change in stock price will also be random.
The efficient market hypothesis has three different forms: weak, semi-strong, and strong form. The weak form believes that the current stock prices have already incorporated all the historical market data, such as prices, trading volume, and published financial information. The technical analysis is the concept of analyzing past security prices and levels of trading volume in an attempt to predict demand. Therefore, EMH and technical analysis are in direct contradiction.
On the other hand, fundamental analysis and insider information can produce above-market returns under the weak form. Additionally, the semi-strong form believes that the current stock price not only reflects the historical price data, but also data from analyzing financial statements, industry, or current economic outlook.
The stock prices in semi-strong will adjust quickly to reflect any new information in the market. Thus, even fundamental analysis is not likely to yield above-market returns. Only insider information may produce superior returns.
Lastly, a strong form suggests that stock prices reflect all public information and private information too. Even traders that use insider information are unlikely to consistently outperform the market. Technical, fundamental, and insider information will not allow investors to achieve consistently strong results.
There are anomalies or unexpected market results and trends that tend to contradict the EMH. The price-to-earnings ratio effect suggests that higher returns can be attained with portfolios that have low P/E ratios. This effect is also the basis for value investing.
There is also the small-firm effect, which links to the number of analysts that follow small size companies. If there are a lower number of analysts that follow a stock, the value of the securities may not be efficiently priced and can result in an undervalued or overvalued stocks.
In addition, there is also the January effect, where stocks tend to decline in value during the month of December and move up in January. Some theories suggest that this is caused by tax-related sales in December, but no isolated causes have been proven yet.
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Strategies for Dealing with Concentrated Portfolios
The most typical problem for a client is that a substantial portion of their wealth is concentrated in a single security. This type of situation is usually found with small business owners and executives with stock options. Concentrated portfolios face unsystematic risk, and it is important to reduce or eliminate this unsystematic risk in investment.
The obvious solution is to sell the security and reinvest the earnings to a diversified portfolio. However, there are problems that come with doing that. There is only a limited market for securities, and the basis in the security is low relative to its value.
Sometimes, the client also has a desire to keep that asset. If the client chooses not to outright sell the security other options can be used such as an installment sale, private annuity, and self-canceling installment note (SCINs), Charitable remainder trusts (CRTs), put options, collar, and an exchange fund.
Security Market Indexes and Averages
Indexes and averages serve as benchmarks for the performance of an investors’ portfolios and the performance of money managers. There are price-weighted indexes and market capitalization-weighted indexes.
A price-weighted index is an index where the value of the index is equal to the sum of the prices of a security in an index divided by a predetermined divisor. The divisor is adjusted whenever a stock split or stock dividend occurs with one of the stocks in the index.
Therefore, a price-weighted index will not accurately reflect the movement of the market value. An equal but opposite change in the price of two stocks will offset each other in a price-weighted index.
The Dow Jones Industrial Average (DJIA) is an example of a price-weighted index. It consists of 30 stock prices that are added and divided by a divisor. It can be advantageous because it is highly correlated to other broader market indexes, and represents the majority of stocks that are traded. Due to this, it is widely popular. However, the DJIA fails to reflect any payment of cash dividends, it ignores the dividends of the stocks that are under 10%. It also does not account for the number of shares outstanding and consists of a biased sample of stocks. This means that industries are not proportionally represented.
A market capitalization weighted index is one that sums the market value of the companies and divides it by the base year value, and then multiplies the amount by 10. It also automatically adjusts for stock splits and dividends.
Common examples of a market capitalization weighted index are the Standard & Poor’s (S&P) 500 Index, Russell 2000 Index, Morgan Stanley Capital International Europe, Australasia, and Far East (MSCI EAFE®) Index, and Wilshire 5000 Index.
There are also other indexes out there that don't belong in one of the two categories above such as the Value Line Composite Index, which is based on the geometric returns from around 1,700 stocks, and the J.P. Morgan Indices that track emerging markets, government debt, and corporate debt asset classes.
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The primary market is where the initial sale of securities are issued to the public. This can be done with an IPO or a syndicate. Underwriting or investment banking has a purpose to assist with the sale of new issues.
An investment bank will evaluate the firm's financial needs, and determine the best investment vehicle to achieve its capital goal. Investment banks are able to do so in a number of ways: firm commitment, standby-underwriting, best-efforts underwriting, and private placement.
The secondary market is where the investors can buy and sell securities that were previously issued. There is the first market which is where the securities are traded such as the NYSE. The second market, or over-the-counter (OTC) market for unlisted securities in the NASDAQ, and the third market, stocks that trade both on the first and second market.
When buying and selling securities, there are different types of orders that can be utilized.
- The first is a market order that gets issued immediately at the market price, they are filled before other types of orders.
- The second type is a limit order. This allows the investor to purchase or sell a security at or above a specified price. However, there is no guarantee that the order will be filled.
- A stop order is one that can be created if the price of the security reaches a specified level. It is usually used to protect investors from large losses.
- Lastly, a stop limit order is one where an order is created to limit order if the price of a security reaches a specified level.
Example 1: Alex determines that Lincoln Corporation is worth $40 per share. The stock is trading between $42-$45, he can place a limit order at $40. If the order is filled, Alex’s purchase price will be no higher than $45.
Example 2: David purchases Alan Corporation for $50 a few weeks ago, and the stock price is currently trading at $125, but he is concerned that the stock price might decline. He can place a stop order at $100. If the stock price drops to $100, a market order would be placed immediately. However, the order may be filled at a price lower than $100.
Example 3: Emmanuel owns 3,000 shares of Inco corp, they are selling at $40 per share, and he is concerned about the price dropping, he places a stop limit order. If he places a sell stop limit order at $35 and the stock falls below $35, the order will become a limit order to sell 3,000 shares at $35 or better. However, if the stock price remains below $35, the order will never be filled.
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This was a very comprehensive review of asset allocation and portfolio diversification. These are the two investing factors that you need to know to be successful. Overall, you’ll want to consider how much risk you want to take because it will determine how heavily invested in stocks and bonds you are. Additionally, it will help you diversify your investments to offset any market fluctuations.
However, if you feel that you need help picking suitable investments for your portfolio, that is completely understandable. Investing is extremely complex and it can help to have a second opinion on your plans.