How Powerful is Asset Allocation?

According to Burton Malkiel, the Chemical Bank Chairman's Professor of Economics at Princeton University and author of A Random Walk Down Wall Street, below is the basic portfolio for a young investor. Malkiel has authored over 125 articles and is the author or co-author of nine other books. He uses proven, time tested strategies utilized by great investors like Warren Buffet and Jack Bogle to make a portfolio that will give you the most bang for your buck.

As one can see the portfolio is composed mostly of stocks, the asset class with the most risk and consequently the largest average return. Then a small portion in bonds, the more conservative asset with slow, steady gains. Thirdly you have real estate. Real estate exposure can come from either stocks like real estate investment trusts (REITs) or owning physical property. Lastly, and with the smallest percentage of the portfolio, you have cash. Some cash should be held to buy, as Baron Rothschild says, "when there's blood in the streets".

The stocks should be balanced with half US stocks, with a significant portion of small cap grow, and half international stocks. The reason behind this is simple; small cap grow and international stocks carry more risk and consequently...more reward. Buying these stocks in your twenties and holding them for years allows your assets to grow faster, and with each passing year, decrease your risk. Remember the longer you hold an asset the less volatile it becomes. As you age and want to protect your massive gains you should slowly pare back your exposure to stocks.

A side note; when I say "risky" I don't mean risky like playing roulette or blackjack, I mean more risky than some of the other stocks or asset classes available.

Now onto the bond side of things. I've mentioned before a good, quick rule of thumb is the percentage of bonds in your portfolio should equal your age. Bonds carry less risk than stocks, offering a more stable, moderate return overtime. Therefore, you should have a small percentage in your portfolio now, in your twenties, and slowly increase that position as you age to protect your gains.

Real estate is another key element in your portfolio. Real estate has traditionally returned 1.5%/year, after adjusting for inflation with NO property management. You can gain real estate exposure by buying a REIT, owning your home, or buying a rental. There are a lot of great articles on here about how to add real estate to your portfolio. However, buying a REIT will give you more flexibility and a lot less responsibility compared to the other forms of real estate.

Lastly, you need some cash. Having cash on hand will allow you to buy when the stock market and real estate prices are depressed (the best time to buy). Exacerbated downward moves in the market create the quintessential buying opportunity. Warren Buffett rarely buys anything unless its at a significant discount (go back and see my post Can You Pass Buffett's Investing Quiz?). When the time comes and the market has dropped 50% (which happened twice in the past 20 years) have cash readily available to take full advantage of the opportunity, people who do make a fortune. Have your eyes constantly searching for these opportunities, they don't exactly present themselves in the most recognizable ways, or at convenient times.

But why does it matter what combination of stocks, bonds, real estate and cash compose your portfolio? The answer may shock you...asset allocation is the single most important factor (that you can control) when determining rate of return. Let me reiterate; the single most important factor in determining your rate of return is your asset allocation, not the stocks chosen within that asset class or when you buy those stocks. Brinson, Hood, and Beebower (BHB 1986) first discovered this in their article “Determinants of Portfolio Performance". They claim the policy mix (asset allocation) explained 93.6 percent of the average fund’s return variation over time. There has been debate over the exact percentage, but most savvy investors today would agree asset allocation is more important than the individual stocks when determining portfolio performance.

Let's recap;

• Asset allocation is the most important factor in determining your return, not the stocks/funds you select.
• Have a large portion of your portfolio dedicated to stocks, specifically small cap growth and international.
• A quick rule; your age should match the percentage of your portfolio dedicated to bonds.
• Have some real estate exposure.
• Have cash on hand to take advantage of the buying opportunities that come around once or twice a decade.
• These percentages aren't set in stone. Some may like other allocations more than others just make sure you have a plan. And do your research, no one likes leaving money on the table...