Asset Allocation

"It ain't what you know that gets you into trouble. It's what you know for sure that just ain't so." - Mark Twain

It is not necessary for an investor to try to be an expert on the following terms and concepts; advisors add value by helping you understand and apply them.

A founding principle of efficient portfolio design is to combine assets with low or negative correlation to each other to mitigate market risks. If that sounds technical, it's because it is. Each asset added to a portfolio can either improve the risk level or make it worse, and the average investor may not be able to assess those correlations.

A second principle - return must be divided by the level of risk to determine the quality of the outcome. Trick question: Investor A's advisor returned 8% last year and investor B's returned 14%. Who did better? The trick is "we don't know" because we don't know the beta risk (I know that was on the tip of your tongue). If beta risk for A is 1 and for B is 2, the risk-adjusted returns are 8% and 7% respectively. This means that B is likely to experience a disastrous drop if he doesn't change course or use risk controls to reduce beta, putting him well behind A over time. Just because you have a large paper gain in a uranium mine in Bolivia doesn't make it "smart" or "lucky", just "risk tolerant" followed by "broke" if you fail to get out properly.

A third principal - the level of risk of the portfolio must reflect the time available and the goals. Note it does not say "the risk tolerance of the investor". A potential mistake for advisors is to match a risk-averse client with a conservative portfolio and a risk tolerant one with a high-risk portfolio. If the risk-averse client has few assets and little time, they will need to be counseled on how to handle their emotions while watching their properly designed high-risk portfolio that can be shown to potentially meet the goal in the required time. Likewise, if our risk tolerant client has ample assets, lots of time and conservative goals, we maybe can avoid taking on tons of risk for risk's sake. Even when successfully controlled, market risk isn't much fun. If we don't need it, we don't want it. Paths and goals drive risk, not tolerances.