Asset Allocation: What It Is, and Why Thinking About It Will Make You Richer

Posted by Alex Frey (@alexhfrey )

Asset AllocationWhat does "investing" mean to you?

To most people, it means stocks. Apple, Google, Facebook, Underarmour -- the news is dominated by talk of which stocks are going up, and which are going down. 

Ss with so many other things, what dominates the news is not a good measure of what is actually important. 

If you have a diversified portfolio (and you really should), all of the data shows that pales in significance next to how much of your portfolio is invested in the stock market overall, and how much of it is in bonds, commodities, real estate, cash or something else. But most people spend a lot less time thinking about that.

Birds of a Feather Flock Together

The basis of the science of asset allocation is that while the Apple's and GE's of the world have important differences as companies, they share many similar characteristics as investments. To wit, Apple, GE, and every other stock in this US...

  •  ...are subject to the same fluctuations in the overall economy. In a recession like 2008, there are unlikely to be any companies that are performing very well. 
  • ...have many of the same investors, be they mutual funds, pension funds, or hedge funds. If stock investors become more greedy or fearful, this is likely to raise or lower all boats. 
  • ...are located in the same country (the United States in this case) and will be subject to the same changing regulations, government policies, Federal Reserve actions, etc. 

These common factors cause the returns of individual US stocks to move together, in line with the "market." 

Of course if you were going to hold a portfolio of one stock, you would want to spend more time making sure it was the right one then you did evaluating the overall stock market. That is because with any individual stock, how the overall stock market is doing is responsible for somewhere between 20 and 50% of the stock's overall performance. The rest is company-specific factors. But when you get a portfolio of more than about 30 stocks, the differences between each individual company start to average-out and what really becomes important is how much money you have invested in the overall stock market, regardless of which individual companies you have invested in. And for a variety of reasons, it's a pretty bad idea to have a portfolio of one stock.

But stocks are just one example of what we call an "asset class." As the name sounds, an asset class is a classification of different financial assets - a grouping of sorts. In addition to investing in stocks - which can be further split into US Stocks, European Stocks, Japanese Stocks, and emerging-markets stocks - you could put your money into real estate, commodities, bonds, or even gold. Many of these asset-classes have very different characteristics than US stocks. The next article will take a more in-depth tour of the different asset classes available to individual investors. 

The 95-5 Rule of Investing

Real-life portfolios such as ones owned by a pension fund or mutual fund are highly diversified, owning hundreds of companies. As we will see later, diversification is a good idea as it is one of the only "free lunches" that is available to an investor anywhere. 

But an implication of this level of diversification is that the "individual stock" component of returns can become relatively insignificant, because once you own hundreds of securities, your return is likely to converge on the market average. You might be able to pick one or two stocks that do really well, but you can't find 300 of them that are all going to be the next Apple. 

This point was empirically confirmed by a famous study that showed that 93.6% of the differences between real-life pension funds were a result of funds' asset allocation. Less than 5% had to do with the selection of individual securities -- such as whether the funds decided to invest in Coke or Pepsi. 

Despite this, most investors spend 95% of their time thinking about individual stocks. This inspired the "95-5" rule of investing: 95% of returns are dependent on asset allocation, an issue that most investors spend less than 5% of their time thinking about. 

Picking Stocks is Zero-Sum, Investing in Stocks is Positive Sum

One of the fundamental reasons asset allocation is the most important aspect of investing is that it enables everyone to win. Investing in stocks is positive-sum, since everyone that invests in the stock market over time can "win. Stock-picking, on the other hand, is zero-sum (or negative-sum if you include the time and expense required to research individual securities) since not everyone can be a winner. For every person that beats the market, someone has to lose to it.

This has important consequences for individuals because the "game" of stock-picking is not played on anything even resembling a level field.  If you are an active stock-picker, most of the players that you are competing with are professionals at large mutual-funds, hedge-funds, and pension-funds. They are likely paid hundreds of thousands or even millions of dollars a year to spend their time doing nothing except researching the companies in a particular industry, trying to develop an "edge." They generally have access to company management, who may give them "wink and nod" kind of indicators of how business is going. They may even illegally have access to insider information. If you are trying to pick stocks in the half-an-hour after work and before dinner, you are competing in a war in which you are likely significantly out-gunned. We will explore  some strategies that you can take to have a reasonable chance of beating Wall Street at its own game in later tutorials, but for now it's important to understand what you are up against. 

Beating the Market is Difficult; Matching it is Easy

The alternative to "beating" the market is to take a strategy of "meeting the market." Some call this "passive investing"; we prefer to think of it as "95-5" investing. In other words, those that do not want to spend time trying to pick stocks that will do better than the overall market, have an easy out. They can acknowledge that 95% of their returns will be a function of their asset allocation anyway, and just spend 100% of their time thinking about this, and 0% of their time thinking about individual stocks. 

Focusing 100% on asset allocation is trivial to do today because of the amazing capabilities of ETFs, or exchange-traded funds (see more on ETFs). 

Having established an understanding of what asset allocation is and why it is so important, the next articles will focus on how you can actually do it, starting with what all of these asset classes you can invest in actually are

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By Alex Frey