Why Asset Allocation Still Works

This tried-and-true investing strategy helps smooth out volatility in your portfolio.

By + More

Kelly Campbell
We have all read the articles saying that asset allocation is dead. At times, many of us have seen asset allocation fail as a strategy in our portfolios. Nevertheless, asset allocation is not dead, it just requires a little adjustment and a different thought process.

Most people confuse asset allocation and diversification. Diversification means not putting all your eggs in one basket. Asset allocation is the process of building a portfolio of asset classes with varying levels of correlation. A little refresher on correlation. A correlation of positive one (+1) means that two investments will move in the same direction. A correlation of negative one (-1) means that they move in the exact opposite direction of each other. A correlation of zero (0) means that they have no impact on one another. Most investors should strive for a correlation closer to zero.

[In Pictures: 10 Ways to Boost Your Social Security Checks.]

In the 1960s, Harry Markowitz came up with modern portfolio theory, which says that having various asset classes in your portfolio reduces your overall risk and potentially raises your return. Most investors have followed this theory for years. But over the last decade, it seems the theory has failed. But make no mistake, the theory holds true. However, due to the world becoming a global economy, you must think of better ways to reduce correlation among asset classes in your portfolio.

20 years ago, the S&P 500 (the domestic large-cap index) and the EAFE (the foreign large-cap index) had a correlation of 0.4. The S&P and the EAFE indices had very little impact on one another. Today, however, they have a correlation of 0.9. Because of the globalization of many companies, these two indices have begun to move more in sync. Therein lies the problem. In a properly allocated portfolio, your investments should not all move in the same direction. That is why you need different levels of correlation. Today, because you cannot get that by investing in the S&P and the EAFE, you need to think differently about choosing asset classes.

[See 5 Retirement Planning Reminders.]

To achieve less-correlated assets, you must search for sectors and investments that react differently to one another in changing markets. The best place to look is in the foreign markets. Look to sectors like global real estate, global fixed income, and emerging market stocks and bonds. You can even use currencies and commodities in your portfolio. Generally, these asset classes have less correlation to each other and together they will lower overall risk in your portfolio. This is the way to get better and more consistent returns, which should be everyone's goal.

[See U.S. News's top-ranked emerging markets bond funds.]

The S&P 500 generally has a standard deviation—a common measure of volatility—of 18, while a well-allocated portfolio using the investments discussed above has a standard deviation of about 12. That translates to about one third less risk.

You are probably thinking that with less risk, you will get less return. In some markets, that is absolutely correct for the short term. Over the long term of five years or more, you will likely outpace more aggressive portfolios primarily because you will outperform in down years.

[See 10 Things You Should Know About Your IRA.]

Remember, if you lose 50 percent in one year, you will need a 100 percent return just to get back to where you started. But with a better portfolio, suppose you only lose 15 percent in that same down market. Then you only need an 18 percent return to get back to where you started. That is much easier to achieve.

So think about more asset classes in your portfolio and don't be afraid to look outside the United States. That is where you will find true diversification and the proper asset allocation.

As always, remember that it is not how much you make, but how much you keep that matters. Good luck and happy investing.

Kelly Campbell , CFP® and Accredited Investment Fiduciary, is founder of Campbell Wealth Management, a Registered Investment Advisor in Alexandria, Va. Campbell is also the author of Fire Your Broker , a controversial look at the broker industry written as an empathetic response to the trials and tribulations many investors have faced as the stock market cratered and their advisers abandoned their responsibilities to help them weather the storm.