What Is Asset Allocation Anyway?

Every portfolio needs six or seven core asset classes.

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Yale professors studied money managers to uncover the source of their portfolio performance. They found that 90 percent of the returns came from the markets where they invested. Less than 10 percent came from the individual stocks they bought, and the timing of buying and selling investments. For example, if they owned small-cap value stocks and that group of stocks did well that year, the performance of that market was the source of their success, not the specific small-cap stocks they had chosen.

That's why sophisticated investors focus heavily on setting well-defined targets for how they allocate assets. To be an "asset allocator," you play by different rules. Every portfolio needs six or seven core asset classes. Conventional wisdom says you should have at least 5 percent of your portfolio—but no more than 25 to 30 percent—in a core asset class. A core asset class has three primary characteristics:

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Unique purpose. Like each instrument in a jazz band, each asset class plays a valuable "role" in different economic circumstances. U.S. treasuries protect you against economic meltdowns like 2008, but they lose value from inflation and slow down overall portfolio growth. Real estate hedges against inflation, provides a steady income stream, and can appreciate like stocks, but is not immune to economic cycles.

Stocks have outperformed every other asset class since 1928, but as we've seen, they can become overvalued, and suffer a decade of volatility and mediocre performance. And if America is growing slowly and countries like India and China are outperforming, investing in foreign stocks gives you a hedge.

Market-based returns. Core asset classes generate returns from a market, not the skill of an investment manager. For example, venture capital, private equity, and hedge funds derive their returns based upon who the manager is and how accomplished he is. Thus, these are not "core" asset classes.

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Access. While many consider fine art an asset class, most everyday investors just can't build a diversified portfolio of paintings, coins, and antiques. The asset class must be broad and deep enough to invest in. It must have a well-established marketplace, not made up of trendy concoctions promoted by Wall Street financial engineers. Thus, managed futures are not considered an asset class.

Non-core asset classes satisfy two of the three characteristics above. Examples would be venture capital, private equity, and hedge funds. Endowments and wealthy families have the resources and expertise to build portfolios consisting of 20 to 25 percent venture, hedge, or private equity funds. But most of us can't do this. Some investors are sold on using a fund of funds to invest in these asset classes, but never consider issues such as: Can you trust the sponsor? Do they have conflicts of interest in their fee structures?

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Moving to the "art" of asset allocation shows how this gets tricky. Here are a few examples:

Sectors. There are 10 basic economic sectors, and within each sector there are industries. Communications equipment and software are industries within the technology sector. Sectors are not asset classes, except the real estate sector, which is a core asset class. The U.S. real estate sector includes apartment buildings, warehouses, office buildings, and retail malls. It tends to behave different than the overall U.S. economy. Your house is not an allocation to real estate because its "returns" are mostly psychological and are limited to residential real estate in your town.

Styles. For 30 years, a great allocation strategy has been to parse out small public companies that have a "value" bent, and allocate to "small-cap value" stocks. This has added significant returns to a portfolio.

Commodities. In the last five years, allocating to commodities has become more acceptable for portfolios. But the debate rages on how to allocate between gold, precious metals, energy, and agricultural products?

Start thinking about your portfolio through this asset-allocation lens. You'll start wondering what you have, and how it will work in the next market rise or meltdown. Now we're talking!

Mitch Tuchman is CEO and founder of MarketRiders, an online investment advisory and management service helping Americans invest for retirement. MarketRiders gives investors greater peace of mind knowing that they are leveraging the best thinking of Nobel Laureates and the investing methods used by the world's most elite institutions and wealthiest families. MarketRiders is on the investor's side, helping reduce investment costs and risks, and increasing retirement savings.