by Bruce Fenton

Asset Allocation, long thought of as a basic tenet of a good investment strategy, is not always every investor’s friend. Controlling risk is important to most when markets are going down, not when they are going up. A good asset allocation model relies on the premise that a portfolio balanced between various asset classes will help control or mitigate investment risk.

In theory, this might be true. But in practice, many investors lack the discipline to make this a truism. The basic problem stems from the emotional disorder afflicting many investors…they buy and hold when the markets are good and sell when markets are bad. In other words they buy high and sell low.

To make asset allocation work, they would have to be willing to buy assets that no one wants, that are down in price, that look as if they will never recover. They would have to sell assets going up in price that everyone wants and that look like they are going to the moon. Not an easy bridge to cross!

The broadest and easiest form of asset allocation to understand is a model based upon equal parts stocks, bonds, and cash. Periodically the holder of this portfolio would sell a portion of the assets gaining value and buy that class going down in value. This requires faith that the asset classes will periodically cycle from low to high.

In strong up markets, this implies selling favorite stocks, for example, and buying low performing bonds. In 1999 or 2000 this concept would have resulted in most financial advisors losing their jobs, since getting a client to sell a prized asset that had just doubled or tripled in value in order to buy a bond earning 5% would have generated a rancorous argument.

An investor building a portfolio around sector analysis would buy sectors that have bottomed and sell those that have topped out. Obviously the trick is to know which is which, and then have the discipline to buy low and sell high.

A second asset allocation model focuses on investment style. Style refers to value versus growth, large cap vs. small cap, and domestic vs. international equities. Style analysis works well when reviewing performance of mutual fund managers where funds have a wide variety of holdings.

Stanford Professor and Nobel Prize winning economist William F. Sharpe pioneered returns-based style analysis. This allows investors the opportunity to evaluate portfolio managers by estimating a portfolio manager’s style by determining the mix of passive benchmarks that best matched the actual returns of the fund. This technique enables an analyst to develop a perspective about how the fund might behave in the future based upon historical performances.

Always keep in mind that historical performance does not guarantee future performance. We are still subject to event risks that can disrupt the ordinary course of events in an economy and the investment markets.

Bruce Fenton is a financial consultant, a writer, and the Managing Director of Atlantic Financial Inc. Bruce welcomes inquiries, comments, and questions. He can be reached by contacting The Fenton Report.