How to Diversify with the Best Asset Allocation for You

CATEGORIES: Investment Planning

What Is Modern Portfolio Theory?At the beginning of the New Year, we are all filled with good intentions for a productive year ahead. Now is the time to act on one of the most important of these good intentions – making smart asset allocation decisions. Here are some tips for making the right decisions around an asset mix best suited to your own return objectives and investment risk tolerance.

Strategic and Tactical Decisions

Asset allocation has both a strategic and a tactical component.  Strategic allocation should be aligned with long-term goals and asset mix weightings should shift only periodically as you progress towards major lifestyle events, like college tuitions, starting a new business, or retirement. Generally speaking, the farther you are away from these liquidity events, the more you will want to orient your portfolio towards low-income assets with higher growth potential over long-term cycles. Small cap and emerging markets stocks fit this description, as do commodities futures. Many market experts consider it a default scenario that markets like China and Brazil will continue to grow strongly compared to the US and Western Europe, while prices for a wide range of commodities from oil to soybeans and copper will keep going up as far ahead as the eye can see. If your time horizon to a major liquidity event is fifteen years or more, you will probably want to be positioned accordingly.

Tactical allocation decisions are more closely aligned with near-term capital markets expectations. Tactical asset allocation is not for everyone – it requires more attention and action from investors on a more regular basis. Ultimately, it may not be worth the effort if you don’t have the time or the inclination to make that commitment.

A Core / Satellite Approach

If you are game to try your hand at tactical allocation, then one approach I find to be worthwhile is the core / satellite structure. What this means is that you designate some percentage of the portfolio as core, which should stay unchanged – apart from strategic evolution as discussed above. The remaining “satellite” or “periphery” component will be reserved for shorter-term tactical decisions. The satellite tends to run from around an aggressive 30% to a conservative 10% (implying a core range of 70% – 90%).

Since the majority of shorter-term activity will take place inside the satellite component, it is a good idea to consider ETFs as the primary asset vehicle for taking on different asset class exposures. Since ETFs trade like common stocks and typically do not have cumbersome restrictions (like redemption fees or lockout provisions), they are well-suited to making fluid tactical decisions. Be mindful, as always, of the trading commissions and other expenses that can detract from performance if used excessively.

Putting it All Together

Once you have settled on your investment goals, risk tolerance, and strategic / tactical approach, it is time to establish a model portfolio with target weights. Let’s start by dividing the universe into the two basic risk categories of equities and fixed income. For an investor with an appropriately long-term horizon, a logical weighting might be 70% equities and 30% fixed income. Apply that weighting to both the core and the satellite components. For example, if your core / satellite split is going to be 80 / 20, then in the core you would have a 56% target allocation to equities and 24% to fixed income (56+24=80). And the corresponding weights in the satellite would be 14% and 6%. All the core and satellite allocations should add up to 100%. This may seem unnecessarily cumbersome, but remember that the core and satellite assets are going to be performing different roles and will probably involve different funds, ETFs, or other assets. So, it is important to account for the core and satellite weights separately. Visually it looks as follows:

Core Portfolio
All Equities 56%
All Fixed Income 24%
Total Core Portfolio   80%
Satellite Portfolio
All Equities 14%
All Fixed Income   6%
Total Satellite Portfolio     20%


Now it’s time to make separate decisions for the core and satellite portfolios. Let’s start with the core. For strategic allocation purposes, we want a broadly diverse range of asset classes in both equities and fixed income. For equities, a good mix may include: large-cap US blue chips; small-mid cap stocks; developed and emerging non-US stocks; and a mix of global growth stocks. In fixed income, appropriate asset classes could include: short-term bonds; intermediate US government & investment grade corporate bonds; municipals; global bonds; and local-currency emerging markets bonds. Here is a hypothetical weighting (will vary by investor – not intended to convey Jemstep’s actual views or recommendations):

Core Portfolio
US Large/Mega-Cap Equities 20.0%
Small-Mid Cap Equities 10.0%
Emerging Markets Equities   8.0%
Developed International Equities 10.0%
Global Growth Stocks   8.0%
Total Core Equities 56.0%
 Short-term Bonds   5.0%
Intermediate Gov’t / IG Corporates   9.0%
Municipals   5.0%
Global Bonds   3.0%
Local-currency EM Bonds   2.0%
Total Core Fixed Income 24.0%


For the satellite component, you may give yourself more flexibility to vary exposures outside equities and fixed income, provided that the risk-return characteristics of the assets you select are similar to whichever class you are substituting. For example, commodities futures tend to have equities-like risk properties, while market neutral long-short funds characteristically exhibit volatility closer to fixed income instruments. Perhaps your near-term assessment of capital markets conditions is that emerging markets stocks and commodities are due for a cyclical upswing, while on the low-volatility side you are wary of adding on new bond exposures given prevailing low yields. This may result in something like the following:

Satellite Portfolio
Commodities Futures   7.0%
Emerging Markets Equities   7.0%
Market Neutral Long-Short   6.0%
Total Core Equities 56.0%



Although the core portfolio will not change by much, if at all, it is important to rebalance the portfolio on at least an annual basis. That is to say, positions which have caused the target weights to increase should be sold and those which have declined should be bought, so as to bring the weightings back in line with the model portfolio. Rebalancing is an important discipline that will keep the portfolio oriented towards the long-term goals with which the asset weightings are aligned.

Smart asset allocation involves some investment of time, particularly for investors looking to benefit from tactical allocation moves as well as strategic decisions. That time investment can provide handsome returns over the long term, if maintained on a regular and disciplined basis.

What are your investment goals as 2012 unfolds, and how well aligned are these goals with your portfolio?

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About the Author

Katrina Lamb is a CFA for Jemstep. She has over 25 years experience in economics, finance, international development and management strategy, with a strong focus on global markets. She provides a voice of clarity, logic, and reason in an environment characterized by high uncertainty.

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