Why Asset Allocation Matters

Last week, I introduced the most important step in building a portfolio: asset allocation. Now let’s take a look at how that idea came about.

Modern Portfolio TheoryLooking at investment portfolios based on managing risk is not a new concept. It dates back to the 1950s, when Harry Markowitz, at the University of Chicago, developed a model of portfolio construction based on the interactions of different asset classes with each other. What he found was that by mixing different asset classes, each with different levels of risk, you could construct portfolios which maximize return for a given level of risk. Conversely, you could minimize risk for a given level of return. These portfolios are known as efficient portfolios.

In other words, by mixing different asset classes together you could actually reduce the risk of a portfolio while maintaining the same future expected return. While each particular asset class or individual security may be highly risky by itself, the interaction of these individually risky asset classes with each other matters more.

Prior to Markowitz’s studies, the emphasis on portfolio construction was to determine whether a stock was overpriced or underpriced and then to buy the underpriced stocks. Modern portfolio theory places the emphasis not on individual stocks, but the portfolio as a whole and how the components of the portfolio interact with each other.

This model was further expanded in the 1960s by William Sharpe, who showed a direct relationship between the risk of a portfolio, or an individual security, and its return. Essentially you could calculate the return of a stock based upon how volatile or risky it is compared to the broad stock market. More volatile and thus riskier stocks should result in higher returns. Recognizing the seminal nature of their work, both Markowitz and Sharpe won the Nobel Prize in Economics in 1990. Unfortunately, Wall Street, and most likely your stockbroker, still emphasize security selection over portfolio management.

The Optimal Asset Allocation

While Markowitz and Sharpe’s models showed a direct relationship between risk and return, they did not address the question of how much risk you should take. Which efficient portfolio is right for you? Or, how do you determine which mix of investments and ultimately the amount of risk that is right for you?

There are three broad ways to determine your risk capacity: your ability, your willingness, and your need to take risk. Your ability to take risk depends on many factors, including your age, income, the size of your portfolio, and other factors. Your willingness to take risk is purely psychological and answers the question, “How much money am I willing to lose before I can’t sleep at night?” Your need to take risk depends on your lifestyle, your expenses, and your financial goals, and is the most important factor in determining your asset allocation. While you may have a high ability and willingness to take risk, if your need to take risk is low, why chance it?

In a future column, I’ll expand on how to figure out your own risk capacity.

This week’s financial prescription: By mixing aggressive investments together, you may reduce your portfolio’s overall risk.