The Alchemy Of Asset Allocation
by Douglas A. Lambrecht, CIMC    8/4/1997

Ancient texts and medical tomes contain references to practitioners of an arcane medical art called alchemy. Alchemists applied their rudimentary chemistry techniques with the mystical arts to create substances that were reputed to transmute energy and promote more rapid healing. Although it is now believed that most of their concocted potions and salves were created through basic reduction techniques, recorded history would leave us to believe that the ancient art of alchemy developed further. Stories of practitioners turning lead into gold persisted through the ages, leaving the world to wonder still whether alchemists really transmuted materials, transformed properties or created the legendary philosopher’s stone. 

While most people today scoff at such stories, many fervent investors still search for similar such magical transformations in their investment portfolios on a daily basis. With record breaking volume, huge inflows of cash into the markets and an unquenchable fervor for profit, investors frantically buy, lend, straddle, put, call, hypothecate and sell all manner of financial instruments, from stocks, bonds and derivatives to mutual funds and annuity products. Collectively, they spend millions of dollars on their education and pore through countless newsletters, books and periodicals. All are in pursuit of an elusive magical formula that will transform portfolios into proverbial pots of gold. 

Fortunately, just as old myths about alchemy were eventually replaced by quantifiable evidence and better understandings of the underlying processes, so too are today’s investors becoming more aware of the essential laws of risk and reward that govern the financial markets. Of all of the insights and valuable knowledge learned about investing, analysts and informed advisors are quick to point out the most important and essential truths can be gleaned from studies of asset allocation. 

“ Investors generally want to take the smallest
possible risk to secure the greatest possible return.”
Dr. Harry M. Markowitz,  winner of the 1990 Nobel Prize in Economics

The study of asset allocation was popularized in the 1950’s by Dr. Harry M. Markowitz , who postulated that “investors generally want to take the smallest possible risk to secure the greatest possible return” Dr. Markowitz’s work, along with subsequent reformulation of similar concepts by William Sharpe in the 1960’s, formed the foundation for modern portfolio theory. This theory holds that the risk of an investment portfolio can be analyzed by measuring the historical variance of the investments held from their mean, in most cases the standard deviations, and combining the resulting findings in proportion to weightings to quantify the underlying volatility. 

Adepts of asset allocation apply these studies to various markets and asset classes in attempts to produce a mix characterized by lower risk and higher reward. They seek to replicate an optimum mix of assets, referred to by the profession as the efficient frontier. The primary objective of such asset allocation is to maximize investment returns while simultaneously reducing overall volatility. As is true with real estate’s infamous emphasis on location, location, location, how well an investment portfolio is positioned or optimized can make a world of difference in its risk adjusted performance. 

There are basically three key elements in the portfolio optimization process: 1) asset allocation, 2) security selection and 3) market timing. Of these, market timing and security selection receive the most widespread media attention and emphasis. Though widely misunderstood and curiously glossed over by many advisors, asset allocation is of preeminent importance, a fact first noted in print in the May-June 1991 edition of the Financial Analyst’s Journal, which is now oft mentioned elsewhere.

“studies have consistently shown that over 90% of investment 
performance is directly attributable to asset allocation.”
Financial Analyst’s Journal,   May-June 1991

For the average investor, the analysis of optimization techniques, discussions of regression from the mean, correlation comparisons and measurements of standard deviation all point back to a simple truth most learned long ago: Don’t put all your eggs in one basket. While that is sage advice, it still leaves unanswered the questions of which baskets to use and how much should be put into each? 

Most major national brokerage firms routinely publish broad asset allocation guidelines allotting 50%-70% into stocks, 20%-40% into bonds and 5%-20% into cash equivalents. Fine-tuning asset allocation is different for each investor, depending upon their investment objectives, tolerance for volatility or risk, time horizons and available capital. A well thought out allocation plan incorporates historical input and market statistics with assumptions about interest rates and growth. Beyond that, determining asset allocation is a bit like driving an automobile: You have to be prepared for what is coming up, while remaining cognizant of what is, and has been, going on around you and behind you. 

Adopting an asset allocation strategy is not entirely passive.  Once determined, a plan should be re-visited at least annually to determine if the underlying assumptions and economic conditions still apply.  While strategic allocation does not infer nor encourage frequent shifts among various asset classes, significant economic events may signal an important reallocation for part of a portfolio. 

The primary objective of asset allocation is to maximize
investment returns while reducing overall volatility (risk).

Generally speaking, investors who set realistic and appropriate investment time horizons, have the available capital and possess a reasonable tolerance for risk are well advised to seek a balanced approach which benefits from participation in both domestic and foreign markets with a healthy mix of stocks, bonds and cash equivalents. Further, since correlation studies show significant divergence between growth and value styles of investing and indicate widely differing performance cycles for small, mid and large capitalization issues, investors with sufficient capital may benefit from some participation in each of these market segments. 

Neither a graduate degree in finance nor an appreciation for the arcane art of alchemy is required to understand the compelling message of asset allocation studies. The conclusions and ramifications on investment performance, unlike an alchemist’s mysterious murky concoctions, are crystal clear. To reduce risk and improve portfolio performance, apply this time-proven formula: 

Properly allocate and diversify holdings, lengthen investment
time-horizons, and let the economic trends work in your favor.