The most common problem or mistake I see among prospective clients or investors is not having the correct asset allocation in their portfolio(s).

What do I mean when I say “asset allocation?” When I say “asset allocation” I mean the mix of stocks, bonds, and cash within a portfolio.

Too often investor’s get caught up in the decision between buying JP Morgan vs. Wells Fargo stock, or Microsoft vs. Apple stock, or Pfizer vs. Merck stock. While those are important decisions, the many decisions leading there are much more important.

What investors fail to remember is that asset classes generally move together. Think about Monday-Wednesday this week (2/15-2/17) stocks broadly rose all three days, finding a stock in the red any of those days was an outlier. The same broad movement behavior continues when looking at longer periods and also when breaking asset classes down into more specific criteria.

By the time an investor gets to the decision between buying JP Morgan or Wells Fargo, they should have already answered the following questions.

1. What percentage of the total portfolio should be in stocks? ( Most Important Question)

2. What percentage of stocks should be US companies, Foreign Developed, Emerging, etc.?

3. What percentage of stocks should be in the different style categories of stocks? (See Equity Style Box below)

4. What percentage of stocks should be in the different sectors of stocks? (Financials, Consumer Staples, Tech, etc.)

5. Is this particular stock a good representative of its category, or is it a possible negative outlier?

Understanding the above questions and answering them, the investor should realize that JP Morgan and Wells Fargo stock are likely to perform very similarly over the next 12 months assuming neither is an outlier.

Assuming an investor can build a broad portfolio of exposure to stocks and a broad portfolio of bonds within the greater portfolio, the weighting of stocks to bonds is significantly more important to performance than the selection of individual stock and bond holdings.

Determinants for Portfolio Performance

1. Most Important: allocation of stocks to bonds to cash

2. 2nd Most Important: allocation of different countries, styles, and sectors

3. Least Important: decision between individual securities which match in criteria (outlier exception)

The decision of an investor to be 70% stocks and 30% bonds, 50% stocks and 50% bonds, 100% stocks, etc., is much more significant to returns than the decision between buying Microsoft or buying Apple.

The typical money manager uses a “risk based” approach to decide what portfolio allocation they will recommend for a client investor.

Risk Based Approach:
The money manager gives the client a “risk questionnaire” to fill out. The goal of this questionnaire is to assess the client’s “risk tolerance.” By inputting the risk tolerance and age of the client into a standardized formula a recommended allocation is generated for the client.

The Many Shortcomings of Risk Based Method

1. The risk method does not take into account what the client’s goals/objectives for their assets. It does not take into account growth or cash flow needs of the portfolio. The most important question in determining portfolio allocation should be “What are we trying to accomplish?”, and this method completely disregards it.

2. These questionnaires assess an investor’s comfort and understanding of volatility. The term risk is misleading. A client investor may not have a great understanding or comfort of risk, they are not professional investors. It is really risky having a portfolio allocation that has a low probability of achieving your goals because your money manager was too lazy or inept to explain the difference between risk and volatility.

3. These methods almost always use a formula involving age to calculate the investor’s time horizon. Age is a factor in determining time horizon, but age alone does not determine time horizon.

4. In this method the client/investor is determining the asset allocation based on their understanding of and comfortability with market volatility. If an investor is going to pay a professional money manager, shouldn’t the money manager make an allocation recommendation for the client?

Goals Based Approach:
Full disclosure, this is the method I use when working with my clients. After taking a full inventory of the investor’s assets, liabilities, current and future cash flows money manager and investor discuss the needs of the portfolio. What does the portfolio need to do? The manager and investor create a hierarchy of goals and objectives that may look like this:

Objective: Meet cash flow distributions of $40,000 annually while maintaining or growing account size.
Goal: Grow portfolio as much as reasonably possible over the investment time horizon while meeting cash flow objectives.

Then a simulation or stress test is performed with different asset allocations to see what allocation gives the investor the highest probability of achieving their goals and objectives.

Shortcomings of Goals Based Method

1. Manager and investor need to successfully define goals and objectives, which can sometimes be difficult.

2. The simulations run to test different allocations make certain assumptions. Typically those assumptions are that stocks and bonds will perform much as they performed in the past. Unfortunately past results is NEVER a guarantee of future results.

3. The simulation does not factor in underperformance or outperformance of the portfolio over its given time horizon.

No method of choosing a portfolio’s allocation is perfect. I do think the Goals Based Method is superior to the Risk Based Method, because it is based on probabilities of achievement instead of investor’s comfort or understanding of market volatility.