Asset Allocation – Let the Fiscal Cliff be an impetus for a portfolio checkup!

While lawmakers attempt to resolve the fiscal cliff (15 days until year end and counting down!) this would be a good time to check in on your portfolio’s asset allocation.  Why?  Because volatility is low[1] and has the potential to increase [See chart #1.]  Moreover, stock market returns have been decent this year after underperformance in the last few years.   Portfolio allocations may need a revisit by investors who are complacent because of healthy returns and who may be making unintended bets on the future direction of the financial markets and their portfolio values.  By paring back winners that have appreciated and are now expensive on a valuation basis (such as price to earnings multiples), gains can be redeployed into cheaper assets before an unpleasant reality check or sell off.  The assumption that capital gains taxes may increase in 2012 is an added incentive.  In any case, systematic rebalancing keeps a portfolio on track.  Below I detail some important tenants:

What is strategic asset allocation and why is it important?

Strategic asset allocation is the long-term plan an investor (individual or institution) sets for financial assets based on specific goals, objectives, time frame and contributions for a set period.  The strategic asset allocation is an investment roadmap for growth that takes into account investor risk tolerance, liquidity needs, requirements specific to his/her objectives and personal circumstances (such as early retirement, need for income over growth or vice versa) and a time frame for achieving these goals.

Example:  For most of us, it is critical to have a plan for retirement so that an individual can measure over time whether the plan is on track.  Academic studies conclude that roughly 85% or more of investment returns over time are attributable to how funds are allocated among asset classes.[2]

What are some components of a successful strategy?

Diversification among asset classes:  A prospective range of investment returns over time are attributable to how investment funds are allocated among asset classes (including stocks, bonds, cash and alternatives – such as hedge funds, real estate, commodities) Of course, this assumes that asset class allocations are diversified and perform according to general market risk, as shown in chart #2, rather that specific security risk. (Security risk is associated with a company or industry.  Examples: Tobacco companies face lawsuit risk associated with the dangers of smoking.  Drug companies face the risk of patent expiration on the drugs and the competition from generics)

Allowing for time in the market as “timing” is not perfect.  While an investor may plan to ride a particular security or asset as it appreciates while vowing to jump out before a sell-off, this clairvoyance is rarely achieved on a consistent basis.  So disciplined “rebalancing” based on periodic readjustments according to a combination of price or calendar guidelines can help maintain intended allocations.

Chart #1:  Volatility, as measured by the VIX, spiked to historical levels during the Global Financial Crisis in 2008 and has subsided to below average rates in the last six months.  Source:  Bloomberg

Chart #2:  The efficient frontier curve (according to Modern Portfolio Theory), illustrates the optimal performance of a diversified asset class given its measured risk.  Source:  Investopedia

Despite the uncertainty, move forward!

Investors have had to grapple with uncertainty, volatility, and a weird investing environment in the past few years.  Interest rates are very low, inflation appears quiescent despite a huge buildup of government debt, unemployment is high and there is excess growth capacity in an economy that could ramp up if demand returned to historical levels.  Internationally, many of our trading partners are also dealing with a low-growth environment and high debt.  Is this a reason to shun the financial markets? No!

Despite the uncertainty and distressing environment, time can be on the side of the patient investor who takes a long-term view toward compounded returns and appreciation.  While nervous investors have rotated into less volatile investments (such as government bonds), there are opportunities in the market due to lower prices of risk based assets.  Set sail and move forward!