What is Asset Allocation?
At the base of any portfolio allocation is the premise that the best-performing asset varies from year to year and is not easily predictable. At the same time, poorly performing investments could be the result of multiple factors including, but not limited to, market conditions, earnings, rumors, and/or changes in board/management. The thinking goes, by having a mixture of asset classes, sectors, and geographies, an investor is best prepared to achieve the best risk adjusted return* by hedging against individual risk drivers while diversifying to capture holistic opportunities.
The laymen’s thinking almost makes more sense — an allocation is the equivalent of a pie (the sum total of different slices). Each slice is the equivalent of an asset class, sector, or geography. As these classes (slices) increase/decrease (grow/shrink) the pie (allocation) must be rebalanced. An investor would effectively sell winners (bigger slices) and buy losers (smaller slices) to get the allocation (pie) back into symmetrical shape. After rebalancing, the allocation (pie) is larger than it was initially — the investor made money by diversifying.
A Note on Risk Adjusted Return*
We live in a risk-reward world, that is the more risk you take the more benefit you might be able to derive from that risk (at the same time, higher risk increases the extent to which you can lose). Entrepreneurs take a phenomenal risk in building businesses. Beyond the financial and time investment, an entrepreneur foregoes the opportunity to build a career and achieve stable income. While they might succeed and profit tremendously from a successful business venture, they may decide to exit the business, losing any investment made while owing significant debt. The term “Risk Adjusted Return,” aims to find that happy level of risk by which a rational and risk averse investor is willing to subject their money to in order to achieve an acceptable return.