Allocation. Allocation. Allocation.
by John Conover

A real estate professional will tell you that the three most important factors in selling real estate are location, location and location. What are the most important factors in managing investments and structuring investment portfolios?

A number of studies have concluded that the single most important factor in determining the performance of an investment portfolio is the asset allocation of the portfolio. Although most of us understand that asset allocation relates in some manner to the diversification of one's investments, it is valuable to understand the reasons why strategic asset allocation is important in order to structure an allocated portfolio.

For the purpose of simplicity, we will use an example investor with the following characteristics:

1. A portfolio of $2,000,000
2. An anticipated retirement in 2012 (ten years)
3. A need for funds at retirement of $4,300,000
4. No realistic expectation of anything better than a "breakeven" income expense life style during the next 10 years
5. No aversion to risk at any level

We realize such an investor would probably never exist and that circumstances are never this clear cut, but we want to maintain a simple example. In order for this investor to reach the goals established, an 8% return over inflation must be achieved.

We structure investments based significantly on historical data. While there is no guarantee the future will be like the past, there are certain patterns of returns in various classes of assets over the long run. We can thus predict, with a fairly high level of confidence, that an investment portfolio consisting of large cap established growth stocks will achieve a return of CPI (our measure of inflation) plus 8% over a ten-year period; the very goal that must be met.

It might appear that our work is done, knowing that an 8% return over ten years is needed and knowing that investing in the large cap established growth sector is likely to achieve that return. There is concern, however, that the ride over ten years might be too "bumpy" even for an investor who is not risk averse.

We take another look at some historical data to see how investments in large cap growth stocks have fared in the past as compared to other sectors. Let's compare large cap growth with eight other sectors (ranging from large cap value to small cap growth) over the past ten years. We know that in 1995 and 1998 the large cap growth sector finished first in performance against the other eight sectors. However, the large cap growth sector fluctuated greatly in the other years, finishing anywhere between second and ninth, as compared to the other sectors. Although achieving results that were as good as or better than the other sectors over the ten-year period, it was a bit of a bumpy ride. Is it possible to achieve the same result with less fluctuation?

This can be accomplished with asset allocation. We can structure an allocated portfolio consisting not just of large cap growth equities, but stocks from other sectors as well. The portfolio will include some stocks that are expected to yield a greater return (with greater risk) and some that are expected to yield a lesser return (with less risk). The blended return for the entire portfolio will have the same targeted CPI plus 8% return. A significant highlight to this portfolio is that it is not exposed to yearly sector fluctuations as it would be if invested solely in one sector. Asset allocation can thus achieve the same result with much less fluctuation.

This method becomes more effective as we invest in asset classes that typically do not fluctuate in the same direction at the same time (correlation), so we build optimal portfolios typically with asset classes which have small or negative correlation. Using correlation and other techniques and measuring tools, we can structure portfolios designed to yield the greatest return for a given amount of risk.

The mission of Cohn Wealth Management is to assist our clients in defining and achieving their financial objectives. We structure asset allocations as a core component of the service we provide our clients. While some of this is science and software, the most important part of our role is to acquire an understanding of what our clients want and need so that we can design personalized asset allocations to meet those goals. For more information on how Cohn Wealth Management can help you, please contact John Conover at (973) 364-0001 or via email at jconover@cohnwm.com.