Six Easy Pieces: Fundamentals of Asset Allocation Explained

March 03, 2014

Figuring out the best split for your assets often seems daunting. But it doesn’t have to be. This template can help you get started.

In the classic book, Six Easy Pieces: Fundamentals of Physics Explained, Richard Feynman made some of the most challenging scientific ideas accessible to a broad readership. Asset allocation is certainly much simpler than quantum mechanics, so we should be able to accomplish the same. These six points are a good way for investors to frame the key questions.

1.       You have assets because you have liabilities

Some investors have liabilities and no assets: governments’ obligations to meet future welfare payments come to mind. Others might even have assets and no liabilities. But most of us have assets because we have liabilities. This is the starting point.

2.       Matching your assets to your liabilities can be expensive

Your liabilities can be estimated. Figure out what you will need to pay out when. Then, aim to have the income you receive on your assets match the expected payments on your liabilities. The surest way is to buy bonds and bond-like instruments where the coupon and principal payments match your expected outgoings with a fair degree of certainty. However, since bond yields are very low today in many countries, this might be expensive; you may need a lot more bonds at today’s prices to match your forecast liabilities.

3.       Not matching your assets to your liabilities can be expensive too!

As an alternative, consider investing in some assets with higher expected returns. If you can find assets with a 6% expected return, you’ll need much less money to meet your liabilities than with assets delivering a 3% expected return. Of course, twice the return probably means at least twice the risk.1 This erodes the fair degree of certainty of the original approach. Returns might be much better—or much worse—than the 6% you expect.

So think about your tolerance for price volatility. Nobody likes volatility, and for some investors it creates regulatory problems. Really bad outcomes can occur when, after a period of poor performance, the higher-expected-return assets are jettisoned, locking in the underperformance. If you are prone to doing this, it’s better to limit your investment in riskier assets. And remember: if you do invest in riskier assets, don’t take full credit today for higher returns that you haven’t yet earned. It’s a classic mistake.

4.       There are two free lunches: diversification and rebalancing

Elroy Dimson of the London Business School once said: “There are many more things that can happen than will happen.” This is the essence of risk. Because we don’t know in advance which of the many things that can happen will happen, we need to diversify our assets. We favor focusing first on things that pay you to own them—bonds pay you a coupon; stocks pay you a dividend; property pays you rent. Spend some of that income on insurance that could pay off should the value of your assets decline beyond a defined tolerance. And apply a disciplined rebalancing process. So, for example, if bonds do better than stocks by more than a predetermined threshold, sell some bonds and rebalance to equities. That way you are selling high and buying low. Automatic rebalancing is a good idea, because behavioral studies show that many investors find it difficult to sell something that has done well to buy something that has not done not so well, and often do the exact opposite. Finally, if you have bought some insurance and the policy pays off, invest the proceeds in other assets at much lower prices.

5.       There are no other free lunches

Some investors might try to time the asset classes they invest in or, within the asset classes, which securities they buy. This is easier said than done. Skill in selecting assets is in short supply, so it’s not available to everyone—and it comes at a cost. It’s not a free lunch.

6.       Know thyself

According to ancient Greek history, Know Thyself was carved into the forecourt of the Temple of Apollo in Delphi. The oft-quoted, oracular, two-time champion world poker player, Puggy Pearson, once said: “Only three things to gambling: knowing the 60/40 end of a proposition, money management and knowing yourself.” The same goes for asset allocation. So ask whether you can afford to match your assets to your liabilities. Can you afford not to? How much insight do you have into what will happen and are you invested accordingly? Self-knowledge is the ultimate key to successful asset allocation.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams. AllianceBernstein Limited is authorised and regulated by the Financial Conduct Authority in the United Kingdom.

1. Technically speaking, because returns are linear and risk is quadratic, twice the return will likely come with four times the risk.

Six Easy Pieces: Fundamentals of Asset Allocation Explained
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