How Important Is Asset Allocation Today?

by: Lowell Herr

Due to a recent Ibbotson study (unfortunately, this article now requires one to register) asset allocation is not the investment elixir today it was thought to be in the late 1980s and 1990s. Nevertheless, it remains the best method for constructing portfolios if the goal is to outperform a broad market benchmark index such as the VTSMX or ITA Index* while reducing portfolio risk.

Readers of ITA Wealth Management know the importance and the efforts we give to holding down portfolio risk. (Check out the ITA Risk Reduction model for additional information on reducing portfolio risk.) Asset allocation automatically pushes the portfolio manager toward diversification, one of the key elements to successful investing.

Not only is asset allocation important, but a subset of AA is that very difficult decision of determining the percentage of the total portfolio one allocates to each asset class. As stated before on this blog, this is the most difficult decision an index investor makes. For the investor who sets up a portfolio through stock selection, obviously the most difficult decision is what stocks to pick for the portfolio. Based on the Ibbotson research, stock selection is about as important as asset allocation.

The problem with Ibbotson, Brinson et. al., and other similar studies is that they divide the portfolio into stocks, bonds, and cash. A study of three asset classes is limited in its usefulness. I've yet to see a study where more complex portfolios, such as the type developed on this blog, are carefully analyzed. Including cash, most of the portfolios tracked here at ITA use between 12 and 17 asset classes. Here is a sample asset allocation plan for a working portfolio.

Click to enlarge.

Click to enlarge

Our portfolios include major asset classes such as developed international markets, emerging markets, REITs, commodities, and international REITs. In addition, we break our stock or equities holdings into sub-asset classes such as Large-Cap Value, Mid-Cap Value, Small-Cap Value, Large-Cap Growth, Mid-Cap Growth, and Small-Cap Growth. Some portfolios will hold large, mid, and small-cap core or blend asset classes.

It is our belief, due to actual portfolio performance data, the more complex portfolios will do better than a total market benchmark as our portfolios are built around the research of Fama-French. Search this blog and Google Fama-French for more information. The research can also be found in our recommended reading such as the Top Ten Investment Books.

ITA Wealth Management is really an ongoing experiment in investing. We do not claim we found the "Holy Grail" of investing. Nor do we presume to have the best answers for portfolio development. However, our core principles, shown below, are worthy directives and goals.

*The ITA Index is a customized benchmark one can set up inside the TLH Spreadsheet. This spreadsheet is available to interested investors and help sessions are available to Platinum members.