Asset Allocation = Risk Allocation
While the current stock market boom has some people rejoicing it doesn’t appear as though their level of anxiety has abated much. Investors sometimes have short memories, but a stock market rally s is not likely to make people forget the carnage left behind in their 401(k) s and stock portfolios after one of the worst market declines in our history. Perhaps at no other time in our recent history have investors been so acutely aware of the risk of investing.
Most investors understand the risk-reward nature of financial markets, known in investment parlance as market risk. Investors who go into the market with eyes wide open do so with some expectation of an amount of money they’ll receive at some future date. Anyone who invests in mutual funds expects that they will get back more than they invested. Some have higher expectations than others; however, those expectations run commensurate with the amount of risk they are willing to assume in order to achieve better results. Others, with a lower tolerance for risk, will be satisfied with lower returns.
Market Risk May be the Least of Your Worries
While investors of all risk tolerances may be rejoicing over the recovery of their portfolios, there are a host of other financial risks looming just over the horizon that, if left unchecked, could wreak even more long term havoc. After nearly two decades of dormancy, risk factors such as inflation, deflation, increasing interest rates, and taxation are rearing their ugly heads, and portfolios that are ill-prepared to cope with them could experience some serious long term consequences.
For younger investors it may require a history lesson to fully comprehend that, not only are double-digit interest rates and inflation possible and they can inflict as much if not more damage as a stock market decline. Of even greater consequence, there are some economists who believe that we may be entering a deflationary period, which, as recent history in Japan and Ireland, as well as our own Great Depression, has shown can lead to severe, long lasting economic stagnation or recessions.
Back to Asset Allocation Basics
Asset allocation has become an established investment strategy for those who understand the long term nature of investing and the need to achieve an optimum level of portfolio balance and diversification in order to mitigate risk and achieve more stable returns. The core strategy involves selecting a mix of asset classes based on an investor’s financial profile, investment objectives, preferences, time horizon and risk tolerance.
The key behind the strategy is the mix of asset classes that, depending on how much or how little they correlate with one another, will create a basket of counter weights that will keep the overall value of the portfolio from tipping too far in one direction. For instance, the correlation between stocks and bonds is relatively low, so that, when stocks perform poorly, bond are likely to perform better. Or, during inflationary periods, precious metals are a well known counter weight to stocks which tend to respond poorly to inflation. A well balanced and diversified portfolio will consist of several different asset classes - stocks, bonds, precious metals, real estate, cash equivalents, etc. - all with varying levels of correlation with one another.
Risk Allocation can turn Risk into Rewards
All investments are susceptible to some form of risk: market risk, interest rate risk, inflation risk, liquidity risk and the risk of taxation. A well planned asset allocation strategy is as much about allocating risk as it is allocating asset, and, when done effectively, the overall risk of the portfolio is mitigated by off-setting the market performances of the various asset classes. A properly allocated portfolio should even welcome economic change and uncertainty as there is more likely be portions of the portfolio that do respond favorably.
Portfolios require frequent tune-ups, also known as rebalancing. Certain parts of the portfolio will perform as expected while others will under-perform or out-perform expectations. As a result, the portfolio can become unbalanced relative to the assumptions and objectives on which the allocation was based. The one certainty about the economy is that it will change as will the risk factors. Most important is that the allocation of assets and risk in your portfolio continue to reflect your needs, preferences, prioritized and your outlook on risk.