An Asset Allocation Primer


To better understand the latest evolution of asset allocation strategy it is essential to understand the components of other manifestations.

ASSET ALLOCATION

...aka, "pie chart" investing, distributes investments so that at all times there is a certain portion invested in equities, fixed income and/or cash. The theory is that this distributes risk. If equities are going down (a bear market) then it is likely that fixed income will be going up or at least staying steady. Likewise, if equities are going up (a bull market) then it is likely that fixed income will be going down. Therefore, by having invested in both, when one goes down the other goes up, thus offsetting loss and controlling risk.

FORMULAIC ASSET ALLOCATION (FAA)

...the strategy behind Life Cycle, Target Date Funds (TDF) and Managed Account funds goes one step further. The theory is that equities are a more risky investment than fixed income (and certainly cash) and that as one gets older they should automatically have a smaller percentage of their money invested in equities and a larger percentage invested in fixed income. For Life Cycle and TDFs the percentage is determined by age level and/or desired retirement age. Typically 80% in equities, 20% in fixed income at age 25 rebalanced 1% each year so that by age 65 there is 40% in equities and 60% in fixed income.

To automatically keep a constant % in equities and fixed income ignoring market and economic conditions -- as FAA requires -- causes two major high level risks that are unnecessary and unacceptable. They are

  1. Maximum loss of portfolio value in a bear market, and
  2. Slower recovery and restricted growth of portfolio value when the market recovers (bull market).

MANAGED ACCOUNTS

...set the percentage allocation according to people's answers to a risk tolerance questionnaire and their subsequent risk "profile." Typically the risk profile and corresponding investments are classified as either "aggressive" (80% equities/20% fixed income), "moderate" (60% equities/40% fixed income), or "conservative" (40% equities/60% fixed income).  This investment mix continues unchanged until a typically infrequent reassessment of the risk profile is taken.

ADAPTIVE ASSET ALLOCATION™ (AAA)

...the strategy behind the HORIZON™ and ReallocateRight™ services, sets and adjusts a portfolio's percentage allocation according to market conditions. The logic is that there is unacceptable risk to keeping money automatically invested in an asset class that will surely produce mounting losses,  i.e., in equities when there is a major downtrend (bear market), or in fixed income during a major uptrend (bull market) which, if done, will severely restrict recovery time.

Under sustained bear market conditions AAA holds that there should be 0% in equities and 100% in fixed income and/or cash. In a sustained bull market there should be 100% in equities and 0% in fixed income. In sideways markets there should be a certain % in both equities and fixed income.