Back in the 1980s, a team of accomplished academics published ground-breaking research, which concluded that asset allocation — the weighting of different asset classes like stocks and bonds in a portfolio — drove more than 90% of the variability of a portfolio’s returns.
The authors of that study, Gary P. Brinson, CFA, Randolph Hood, and Gilbert L. Beebower (known collectively as BHB) went on to suggest that aspects of active management, which so often are the focus of many investors’ attention — things like security selection and market timing — only play relatively minor roles by comparison.
Why is asset allocation such an important element of investing performance and what steps should you be taking to address it in your portfolio?
The idea of employing strategic asset allocation when constructing your portfolio relies on the premise that different asset classes are not perfectly correlated.
An investor who follows a diversification strategy in their portfolio by buying a variety of different asset classes should be able to optimize their investment performance by not only increasing their overall returns but also simultaneously minimize losses owing to volatility or short-term market swings. The idea is that the market prices of fixed-income securities like bonds and preferred stock will generally move in the opposite direction to that of publicly traded stocks.
That’s because when the central bank raises its policy interest rate, the yields on publicly traded fixed-income securities will often move up in lockstep, meaning investors essentially get to earn higher yields on their fixed-income investments.
However, at the same time, higher policy interest rates will also tend to result in higher borrowing costs for businesses, which not only increases their annual interest expenses but also makes it more difficult for them to raise the capital needed to fund future growth projects.
The end result is that stocks will tend to decrease in value when rates go up, but higher expected returns from the fixed-income portion of your portfolio will at least help to offset some of this risk, not only adding to returns but minimizing your losses, or “drawdowns.”
Some active portfolio managers will even employ a strategy of tactical asset allocation where they will attempt to anticipate changes in interest rates in a manner that will help to add alpha to their portfolio returns.
However, the reality is that most investors don’t have access to these types of strategies as they are simply too costly to implement and stay on top of.
How you can address the issue of optimizing asset allocations
It probably isn’t reasonable — or practical — to expect the average retail investor to put in the time and effort required to actively monitor central bank policies and the shape of the yield curve, but that doesn’t mean that there still aren’t “workable” solutions out there for you.
Take, for example, two sectors of the stock market: REITs (real estate investment trusts) and financial institutions.
When interest rates go up, financial institutions. such as banks like Toronto-Dominion Bank (TSX:TD)(NYSE:TD) and even smaller lenders like Canadian Western Bank (TSX:CWB) will benefit from charging higher rates on their loans and mortgages.
Insurance companies, firms like Manulife Financial (TSX:MFC)(NYSE:MFC) and Sun Life Financial (TSX:SLF)(NYSE:SLF), stand to benefit from earning higher rates on the fixed-income portfolios that they manage to reimburse clients for their insurance claims.
Meanwhile, when rates fall, REITs, like Brookfield Property Partners (TSX:BPY.UN)(NASDAQ:BPY) and several others will tend to outperform as they stand to save money on from lower interest rates charged on the mortgages backing the properties they own in their portfolios.
In following a diversified approach to portfolio construction, maybe you won’t be expecting to hit as many “home runs” as you would if you made big bets on a specific stock, sector, or economic report.
But you will stand to hit many more “doubles” and “singles,” which, while they may not be quite as popular as “the long ball,” will go a lot further to helping you secure a more stable financial future.
Stay smart. Stay hungry. Stay Foolish.
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Fool contributor Jason Phillips has no position in any of the stocks mentioned.