Getting the big stuff right
Joel Dresang: Kyle, if diversifying our investments is a matter of putting all of our eggs in more than one basket, actually putting the eggs in baskets is the role of asset allocation. Can you talk about that a little more please?
Kyle Tetting: We look at trying to create a portfolio that meets objectives, try to create a portfolio that manages risk. And asset allocation is the tool that we use to really make sure that what we’re doing in a portfolio lines up with those objectives.
Joel: So it’s putting investments in bonds and stocks and making sure that you’re looking at the risks and rewards and how they play against each other?
Kyle: Absolutely. If you look historically at the returns of say, an all-bond portfolio or an all-stock portfolio, certainly, there are benefits to having one or the other. But there’s an even more significant benefit to having a mix of the two. That’s in their ability to both capture returns and reduce risk.
You look at the stock side of things as kind of the historically riskier asset but which has produced greater returns. You look at the bond side of things, which is historically a little bit more conservative but a little bit more stable, slow returns. And it’s a good mix when you put the two together.
Joel: And it’s not just stocks and bonds anymore.
Kyle: It’s not. If you look at some of the historical studies, they really did focus on those two asset classes, but even just in the last 10 years, we’ve seen a pretty big influx of investment products – everything from real estate and commodities to some very non-traditional asset classes, hedge-fund type strategies, things that you really need to understand what you’re investing in before you dive in head-first. But if you truly understand it, and you can tolerate the risk, there is a place for those kinds of things in a lot of portfolios.
Joel: So why is asset allocation so important?
Kyle: You look back at the Brinson, Beebower, Hood study from 1986 and subsequent studies, which have pointed out that more than 90% of the variability of portfolio returns is accounted for in asset allocation. And so if those other things only account for 10%, we want to make sure we’re focusing on that one thing that’s really going to drive the returns. And so that’s why we focus so much of our energy on making sure that we’re allocating properly towards an individual’s objectives.
Joel : Things like stock selection, market timing, those aren’t as consequential.
Kyle: They’re not. They account for that last 10%. And that doesn’t mean that we’re going to completely exclude the security selection, the timing stuff. There are ways that we can incorporate that into what we do. But we want to make sure that we’re getting the big stuff right.
Joel: So, what’s an ideal asset allocation?
Kyle: There really isn’t one. It’s about understanding the individual’s needs. If those needs are to have a very conservative, slow-growing portfolio, maybe it’s overweighting certain asset classes that are a little bit more conservative. But for a lot of people, they can afford to take more risk or they just want to take more risk. So it’s about, again, mirroring those objectives with ultimately what we decide to put in a portfolio.
Joel: So you’re looking at risk tolerance, time horizon.
Kyle: Yeah. We absolutely are, and ultimately that’s very specific to the individual and not just risk tolerance and time horizon but wants and needs as well. For many clients, many individuals, those are the things that will ultimately drive what they have in their portfolio.
Kyle Tetting is director of research at Landaas & Company.
Joel Dresang is vice president- communications at Landaas & Company.
Money Talk Video by Peter May
Watch Kyle Tetting in Talking Money: Modern Portfolio Theory
Watch Steve Giles in Efficiently Allocating Assets
Read about Efficient Frontier, with links to further resources
(initially posted March 20, 2015)