Asset allocation is a term regularly used in the investment industry. A close cousin of diversification, it refers to the division of an investor's dollars between a variety of different "asset classes," and is generally considered to be a tool to control risk.
The two most basic asset classes are simply stocks and bonds.
There was a time when simple "models" were employed by institutional investors, such as pension funds, with the rule of thumb formula being a portfolio of 60 percent stocks and 40 percent bonds.
The large investment firms all still employ "strategists" who regularly publish their stock and bond allocations. These highly compensated pundits will even issue press releases whenever they change their asset allocation. Back in the days of market mania, just the mention that Goldman Sachs' strategist Abby Joseph Cohen had increased her asset allocation into stocks would send the market marching higher.
When asked about these asset allocation models at Berkshire Hathaway's 2004 annual meeting, Warren Buffett had this to say: "The best way to minimize risk is to think. And the idea that you say, 'I've got 60 percent in stocks and 40 percent in bonds,' and then you have a big announcement that, 'Now we're moving our allocation to 65/35,' as some do ... that's pure nonsense."
Today however, the investment industry takes a more comprehensive view of asset allocation and these models are found in investment literature in the form of colorful pie charts.
Now with all these slices of the pie, investors are confronted with an overabundance of asset classes from which to choose. Asset classes have been divided into large-capitalization stocks, mid-cap stocks, small-cap, foreign and "emerging country" stocks. The pie can further be carved into growth and value stocks for each of these asset classes.
Bonds are divided into government issues, corporate bonds, mortgage securities, highyield or "junk" bonds, and foreign fixedincome securities.
Other slices are reserved for asset classes such as real estate investment trusts. Even commodities are working their way into a slice of the pie. Timber, for example, is a prominent investment holding in Harvard's endowment fund.
Boston-based investment firm Grantham Mayo Van Otterloo is one group that has been successful at identifying undervalued asset classes. And in our opinion, the search for underpriced securities is where asset allocation is most useful to an investor.
At times, the markets will overvalue or undervalue an entire asset class. In early 2000 at the peak of the market, as an example, rational analysis would have pointed to an overvaluation in large-cap growth stocks and an undervaluation in smaller value stocks. An investor would have weathered the market decline and achieved attractive returns by simply selling large growth issues and buying undervalued small company stocks.
Investors should be wary of asset allocation programs that advocate spreading their funds over a wide spectrum of asset classes, which means too many slices in the pie. In such cases, the investor will encounter the same predicament broad diversification poses-high investment costs for average market performance at best. Instead, much like the investor who wishes to be well diversified, an asset allocation "pie" with many slices can be constructed with low cost index funds.
In our own work, we pay little attention to asset allocation. Instead, we are looking to purchase any security, large or small, when our research indicates we are receiving more in value than the price we must pay. When securities that meet our criteria for purchase are difficult to find, we are willing to hold cash equivalents until they surface.