Asset Allocation: Part Art, Part Science

Submitted by The Avenue Wealth Management Group. Reprinted with Permission

What is Asset Allocation?

This investment decision involves the division of a portfolio among multiple asset classes – the broadest mix being equity, fixed income, and cash – and depends greatly on individual goals, time horizon, and risk tolerance.

Simply put, if an investor utilizes multiple asset classes that behave differently in any given market, the portfolio will be positioned to potentially avoid significant losses over time, as each piece of the pie should move in a different direction or to a different degree. This is called diversification. By choosing the right mix of non-correlated assets, the overall portfolio risk is potentially reduced and its return stream may be smoother.

Asset allocation should be used primarily for risk management, and secondarily for return generation. After all, if you don’t have enough risk in your portfolio, you may not reach your financial goals.

The Science: Asset Allocation as a Risk Management Tool

Asset allocation is commonly used to diversify a portfolio, or in other words, attempt to reduce the portfolio’s risk and smooth out returns over time. One of the most important decisions to make from a risk standpoint is how much equity to own versus fixed income. The importance of this decision lies in the fact that the majority of your portfolio risk has historically been derived from equity exposure while fixed income has been one of the only traditional asset classes that tends to move in the opposite direction. Investment-grade bonds have generally performed well during periods of equity market stress.

There is more to asset allocation than simply owning stocks and bonds; it also involves owning equities that are not perfectly correlated with each other, such as U.S. and non-U.S. stocks. Within U.S. equity markets, there has been a benefit to owning both large and small-cap stocks, and correlations between these investments have actually decreased over the last 40 years.

The Art: Asset Allocation as a Return Generator

There are various investing principles that should, in theory, yield positive excess return over the long run. Keep in mind that what markets should do, and what they actually do, can be quite different. There are other factors that warrant consideration when analyzing investments, such as profitability, quality of market, and current investor sentiment. Just as markets don’t operate in a vacuum, investors don’t always make choices solely based on “investment sense.”

Asset allocation analysis typically yields a recommended portfolio containing some level of international equity exposure. Looking back at 2015, this allocation hurt investors relative to domestic equity, regardless of its attractiveness from a valuation standpoint. In this case, exchange rates were a key driver in performances as the U.S. dollar had an unprecedented rally versus other currencies and erased a decent year of returns in unhedged international developed markets. So, just because it makes “investment sense” and you believe it should produce higher returns, doesn’t mean it always will. By contrast, in 1994-1998 U.S. equity markets, especially large cap, outperformed most investments while valuations continued to rise. Does this mean you shouldn’t bother with asset allocation? I think not!

A Long-Term Approach to Asset Allocation

The key to successful investing is formulating a proven process with realistic goals and sticking to it. Abandoning ship in the height of the storm can have catastrophic effects on your long-run performance as you may never completely recover from those losses. Think of the stock market in the same sense that Milton Friedman thought of the economy, in that it behaves like a “plucked string.” The farther you pull on it, the more forcefully it snaps back.

A strategic asset allocation portfolio should never generate the highest returns possible and, on the other hand, it should never produce the lowest either. Historically, the upside has taken care of itself over time. Remember that the primary goal of asset allocation is risk management.

Asset allocation does not guarantee a profit nor protect against loss. IRA withdrawals may be subject to income taxes, and prior to age 59½ a 10% federal penalty tax may apply. Rolling from a traditional IRA into a Roth IRA may involve additional taxation. When converted to a Roth, the client pays federal income taxes on the converted amount but no further taxes in the future. Unless certain criteria are met, Roth IRA owners must be 59½ or older and have have held the IRA for five years before tax-free withdrawals are permitted. Additionally, each converted amount is subject to its own five year holding period. Investors should consult a tax advisor before deciding to do a conversion.
The Avenue Wealth Management Group. An Independent Firm 1360 Caduceus Way Building 800 Suite 101 Watkinsville, GA 30677. Securities offered through Raymond James Financial Services, Inc. Member FINRA/SIPC Material created by Raymond James for use by its advisors.

Formerly known as TSD Capital Group, The Avenue Wealth Management Group is an independent firm of Raymond James Financial Services. Our diverse team offers a wide range of experience and expertise; specializing in wealth transfer, wealth accumulation, asset protection and retirement planning. The combination of our strengths and individual areas of focus enables us to help each and every client we serve to be prepared for each particular avenue of wealth management. The Avenue Wealth Management Group is independent of Raymond James Financial Services. Securities offered through Raymond James Financial Services, Inc., member FINRA/SIPC Tele 706-621-7550/866-651-7556