Investment Diversification Using Asset Allocation
By Stephen J. Mayor Financial Advisor

Most of us have heard the saying: “Don’t put all of your eggs in one basket.” For years, financial experts have urged investors to spread their money across different types of asset classes—such as stocks, bonds, and cash—in order to help reduce risk and enhance long-term returns.

Yet, all too often investors ignore this advice, pouring the bulk of their funds into a relatively narrow handful of investments – or even into a single stock. Although diversification does not ensure against loss, it can be and important factor to helping you achieve long-term financial success. This article will explore some of the many factors that must be taken into account to construct a properly diversified portfolio.

Modern Portfolio Theory

The concept of diversification finds its roots in Modern Portfolio Theory. This theory states that portfolios created using a mix of different asset classes and investment styles should deliver higher returns with less risk than any one asset class would by itself. The goal of asset allocation is to identify the best possible combination of stocks or other assets, based on their expected returns and the expected fluctuation – or volatility – of those returns over time. With this knowledge in hand, investors can construct portfolios that reflect this optimal mix as closely as possible.

Portfolio Performance

The usefulness of an asset class in a portfolio is based on its expected rate of return and volatility, plus the correlation between its performance and that of the rest of the portfolio. Correlation is a statistical measure of the degree to which the returns on different assets move in the same direction at the same time. Modern Portfolio Theory predicts that the lower the correlation, the more likely a particular asset class will improve long-run portfolio performance by smoothing the volatility of returns. Thus, even asset classes with relatively low expected returns and/or relatively high expected risk may be worth including in a portfolio, if the correlation with the other asset classes in the portfolio is low enough.

Because of these benefits, a properly diversified portfolio should yield higher expected returns and/or lower expected risk than any of the specific asset classes in the portfolio. A properly constructed portfolio should reflect the best possible trade-off between expected risk and expected return given the various possible combinations of assets. The process of creating such portfolios is called portfolio optimization, and is a critical element of any asset allocation plan.

Asset Allocation Process

Developing an asset allocation strategy requires an in-depth statistical analysis of asset class performance. While this process begins with an analysis of historic risk and return results, it shouldn’t end there. The capital markets are constantly evolving, and what occurred yesterday might not happen tomorrow. With many different variables and strategies impacting diversification decisions, many investors may find it difficult to chart an appropriate course.

In order to make the best decision, it is important to consider the factors that impact your asset allocation strategy. Besides past performance, we have mentioned that the expected returns, volatility of an asset class, and the correlation between the two influence the portfolio performance and should impact your decision on which assets to allocate.

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