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Why Asset Allocation is Critical to Managing your Portfolio

One of the side benefits of being on my company’s pension committee is that I get a plethora of great investment information quarterly, but what I most look forward to is a table showing the performance of various asset classes over time. I affectionately call this the “periodic table of investing”, similar to the periodic table of the elements, as both contain a bevy of useful information if you know how to interpret them. What is fascinating is how often the asset categories that are the best one year flip completely the next. For example, in 2011 Emerging Markets had a negative 18.4% return ranking it dead last, but in 2012 had a positive 18.2% return ranking it first. Treasury income protection bonds known as TIPS, a staple for conservative investors, did the same ranking –  dead last in 2010, and then best in 2011.

Another surprise is the large swings there are by asset category from one year to the next. Looking at REITs (real estate investment trusts) show returns moving from negative 39.1% in 2008 to positive 26.3% in 2009. It’s also pretty rare when a category has 3 consecutive years of greater than 10% returns. On the goods news front – all asset classes earned a total return above inflation for the period.

Category Total Return GAGR * Standard deviation
Emerging Markets Stocks 264.10% 9.00% 0.38
Small Value Stocks 222.80% 8.10% 0.19
Real Estate 219.50% 8.10% 0.22
TIPS 188.70% 7.30% 0.05
High Yield Bonds 176.20% 7.00% 0.18
Bonds 137.90% 5.90% 0.03
Balanced of stocks and bonds 122.80% 5.50% 0.1
Large Value Stocks 115.90% 5.30% 0.17
Europe, Asia, Far East (EAFE) Stocks 90.80% 4.40% 0.23
Small Growth Stocks 81.50% 4.10% 0.26
Large Growth Stocks 70.10% 3.60% 0.24
Commodities 59.80% 3.20% 0.29
Annually re-balanced portfolio 179.40% 7.10% 0.15
Inflation (CPI) 56.50% 3.00% 0.03
* CAGR = compound annual growth rate
Standard deviation is a measure of volatility – the larger   the more volatile

 

The asset class with the lowest volatility as measured by standard deviation is bonds, as expected, with Large Value stocks as the least volatile of equities. The most volatile is Emerging Markets followed by Commodities and Small Growth stocks. What’s the best? If you look at total return and factor in volatility, I would say Small Value stocks as they had the second best overall return but about average risk and half the volatility of Emerging Markets.

So what does all of this mean? It shows the importance of asset allocation which is balancing returns by using a variety of investments and it also shows why you should not be chasing the “hot” category as looking in a rear-view mirror may cause you to crash. If an investor had re-balanced their portfolio to an equal weighting of the 12 asset classes each year that investor would have earned a total return of 179.4% over the 15 years which is a compound rate of 7.1% with lower risk. And remember, if your portfolio goes down 50% in a year it needs to go up 100% the next to be even over the 2 years.

Investors should consult their advisors to determine the proper investment allocation suitable for your situation.

 

 

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