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Asset Allocation--how to diversify a portfolio to manage risk

| May 28, 2020
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(Edited and re-posted from a 2017 post on my firm's old blog site)

Asset allocation is widely regarded as the primary investment strategy used to balance risk and reward.  Diversifying a portfolio among the main asset classes (stocks, bonds, and cash) is how we craft a portfolio suitable to each Investor Profile.

Diversification generally works to manage risk because each asset class experiences different, and often uncorrelated, ups and downs.  How much we invest in each asset class, and in the sub-classes thereof, greatly influences our long-term gains and the volatility we experience along the way.

Generally, more in stocks for more aggressive investors and more in bonds for more conservative investors.

For my clients, I follow the asset allocation guidance derived from Nobel Prize-winning research.  How much to put into which strategic asset classes and the sub-classes thereof.  Yacktman Focused Fund, for example, is for the large-cap U.S. value portion of the portfolio, while T. Rowe Price Blue Chip Growth fund is for the large-cap U.S. growth portion.  They usually perform differently.  YAFFX, for example, was only down 23% when the market was down 37% in 2008, and in 2009 it was up 62% compared the 24% for the market.  No way to know which will do better or how a fund will do, so we diversify to strike suitable balance of risk and reward.

My investment selection process is rigorous.  I have a massive database and hundreds of filters available therein.  I seek out any mutual funds with Gold, Silver, or Bronze “Analyst Ratings” from Morningstar (that independent firm's subjective professional opinion of how the funds stack-up against their category peers; not the same as their performance-history-tracking “Star Rating”), and then I compare any contenders before choosing the best fund for each category.  Much like a a sports team, I’d rather have an all-star at each position than an average player, but I make sure I'm using players (mutual funds) that are worth their cost.

  • Investor Profiles:
    • Aggressive = 95% stocks and 5% bonds/cash
    • Moderately Aggressive = 80/20
    • Moderate = 60/40
    • Moderately Conservative = 40/60
    • Conservative = 20/80
    • Very Conservative = 10/90
    • Note:
      • Most working folks are Moderate to Aggressive; most retirees are Conservative.

Generally, small-cap and foreign stocks are more volatile and l.

  • Sub-Classes for more specific diversification:
    • Stocks (large, medium, or small companies... growth or value stocks... USA, developed-market foreign, developing markets...)
    • Bonds (corporate, government, domestic or foreign, high-quality/low-interest or low-quality/high-interest, and so forth)
    • Commodities
    • Cash
    • Notes:
      • Generally, stocks are more volatile and have a wider range of returns, bonds less so.
      • High volatility is riskier and low volatility is safer.
      • More risk is correlated with better returns, less risk usually means lower returns.
      • A typical retiree needs to be safer, and a saver with 20+ years to retirement can probably afford to take more risk.

  • Implementing Asset Allocation
    • Client risk profile is the first step.  We use a risk profile questionnaire and thorough discussion with my clients.
    • Investment product suitability is the next step.  For my clients, I use mutual fund portfolios of my own design, allocated according to the strategic asset allocation guidance of trusted sources (usually it's Ibbotson's work that's now owned by Morningstar). Specifically, I offer clients my Strategic, Schwab Index, and Flex portfolio models. Each has a different take on how to implement Asset Allocation. Strategic III models are my preferred portfolios now.
      • Over time, we'll shift from Aggressive on down to Conservative--the closer you get to retirement, the more conservative. Usually about every 5-10 years we'll downshift by re-allocating the portfolio.
      • I use best-of-breed mutual funds to populate each part of the Asset Allocation of each model.
    • "Target Date" funds do it all for you ongoing. You could put everything into a target date fund and leave it there forever, and employer-sponsored retirement plans often offer such and even put you into them automatically.
      • You're in a "The 2045 fund can be used forever by anyone expecting to retire around Year 2045.
      • But they usually use only their own in-house products. Your Nationwide Destination 2045 fund at work uses only Nationwide products. The results have been very good lately, but not as good over the long-term.
    • "Allocation Funds" are like Target Date funds in they are total portfolios in one fund, but they don't change over time--an Aggressive allocation fund remain so, so you'd exit that one and move into a Moderate or Conservative fund as you get closer to the retirement year.
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