Asset Allocation Can Create an Unintended Wild Ride
Investors are told over and over again that Asset Allocation, the act of divvying up a portfolio into stocks, bonds, and cash, is the single most important decision they can make when it comes to investing. Investors are also often told that their asset allocation will be the principal determinant of their investment results.
Is it really?
No. Not exactly.
The problem with asset allocation is that it is quite imprecise. Your portfolio’s asset allocation doesn’t tell you much about how it will likely perform. Just because something is called a “stock,” or a “bond” doesn’t make it behave the same as all the other stocks and bonds. In reality, two portfolios that both have 60% invested in stocks and 40% in bonds (“60/40”) can behave quite differently.
More problematically, many bond investments can behave a lot like stocks. For example, less-than-investment grade bonds, otherwise known as high-yield bonds or “junk bonds” can experience significant swings in their price. These bonds do not behave at all like U.S. Treasury Bonds or other higher quality bonds. Loading up your 60/40 portfolio with high-yield bonds could effectively make the portfolio behave more like an 80/20 portfolio.
This problem does not just present itself with high-yield bonds. Many investments suffer from a classification issue in that they do not fit neatly into either a “stock” or “bond” bucket. Many are simply “stock-like,” or “bond-like,” or even hybrids of both. Examples of such hybrids include real estate investment trusts (“REITs”), master limited partnerships (“MLPs”), insurance-linked securities (“ILS”), high-yield bonds, convertible bonds, preferred stock, etc. How does your financial advisor classify these hybrid investments?
And, the challenge is further magnified when investment managers take many of these stock-like and bond-like investments and combine them to create diversified funds. Such examples include hedge funds, global tactical allocation funds, income funds, multi-sector bond funds, target-date funds, market neutral funds, long-short funds and commodities funds, to name just a few! Given the classification issues with these types of funds many advisors just throw up their hands and call them alternatives.
So you can see that asset allocation really isn’t very useful if you are trying to understand and manage your portfolio’s downside risk. Your 60/40 could be every different from another investor’s 60/40, and more importantly, may not behave in a way that is consistent with your expectations of a 60/40 portfolio. You may be exposed to a whole lot more risk that you desire to experience!
Before you get too discouraged, there is a better and simpler way.
It’s called a Risk Number.
A risk number displays the downside risk in a portfolio using one number. It can range from 1 (investments with no volatility like cash) to 99 (the most volatile stock you can find). The risk number combined with your portfolio value tells you how much your portfolio could lose over any six-month period. Think of the risk number as the speed limit for your portfolio. No longer do you need to experience a wild ride – you can now control the speed. You can’t nail down 100% of the risk in a portfolio, that’s simply impossible. But by taking out the 5% of the risk that can’t be controlled, you can manage the other 95%.
The risk number also allows us to stress test your portfolio to see how it would have fared through various market events over the last 8 years, including the financial crisis and recovery. Knowing how bad things could get will help you cope if some of the worst-case scenarios ever play out again.
By becoming aware of and managing your portfolio to a risk number, you no longer have to worry about whether your bonds are behaving like stocks or whether your stocks are more like bonds. By dialing in your risk number your portfolio will behave like the diversified portfolio that you intend.
Even more important than that, you can now align your portfolio’s risk number with your personal risk number – which indicates your willingness to experience market volatility. With a simple 5-minute questionnaire you can pinpoint your risk number. If your personal risk number is 45, then it won’t make much sense to invest your portfolio at 75. Using the speed limit analogy again, why drive 75 mph if you only need or want to drive 45 mph? Driving faster than you need is risky and it just invites a bad outcome. The same is also true of investing.
With our innovative risk number tool and our other planning tools, we can help you take the guesswork out of your financial future.
If you would like to determine the speed limit for your portfolio, please take this test drive: Discover Your Risk Number
Cern Basher, CFA
President & Chief Investment Officer