At first thought, it seems like a stretch to say that a concept as arcane as your asset allocation will determine your financial future. But if you broaden the normal definition of asset allocation to include all of your assets, the statement is very reasonable. In addition to stocks, bonds, mutual funds and cash, your financial assets also include your ability to earn an income, social security, pensions and real estate. Each one of these assets has different characteristics of probable return and associated risk. The way in which you mix your assets will determine the total return you can expect.
Asset allocation assumes that you have multiple assets of
different types working for you. This also implies diversification of asset types to a
greater or lesser degree. If you choose to pin your results on only one asset
type, such as your personal earnings power or a stock investment, the outcome is much
riskier and less predictable than if you have a collection of assets to fall
The return that you can expect from only one or two assets will be highly variable. Depending on the asset, you might either earn or lose money. The outcome depends upon the economic forces acting on that specific asset while you hold it. On the other hand, if you hold many different assets, the return will be the average of all the assets. It will be far more predictable and much less likely to be either extremely high or low.
If you hold a number of individual investments of a similar kind, like houses or large company stocks, the return and risk characteristics you will achieve will be strongly linked to that type of asset, or asset class. By holding a moderate number of examples of the asset class, the performance of any one holding will not make a significant difference in the overall result. In fact, Gary Benson, in a 1993 study, showed that for mutual fund investments, 93% of the outcome depended on the asset class of the investment, while only 5% was related to the stock-picking prowess of fund managers.
In order to diversify well, it is important to make sure that your assets are not highly correlated. For example, owning five houses in five different parts of the country will be less correlated, more diversified, and less risky than owning five houses on the same street.
But as we saw in 2008, holding only one asset class, like houses, can be a risky proposition. By holding a mixture of asset classes, the results of any one asset class will not have an overwhelming effect unless the classes themselves are correlated. For example, if the Social Security system fails, but you still own a house, stocks and bonds then you can expect to have alternate sources of income. If the cause of the Social Security failure is a general economic melt-down, however, then your stock and bond investments could be affected as well, due to correlation.
The good news is that consistency in return and risk characteristics for an asset class makes it possible to estimate future returns based on historical experience. We can find the average past return of an asset class and its historical variability from that return (also known as your risk). The bad news is that at the times when an asset class is over-valued, those assets will tend to underperform the average for some time. A desired return for a financial plan can then be targeted within a defined risk limit by adjusting for valuation and also adjusting the overall mixture of assets.
The planning target may or may not be actually achieved, but using this kind of an approach is a better way to make future plans than by buying an assorted mixture of financial products and hoping for the best. In either case, the lead statement on this page will still be valid. No matter what approach is chosen to select assets, your financial future will be determined by that selection. It follows then to try to make the selection as good as it can be. LFM&P can help you.