Diversification for Asset Allocation – A Random Walk Down Wall Street

After reading the book “A Random Walk Down Wall Street”, I came to realize that investment is a lifelong lesson. Either you are an individual investor or an asset manager, the central goal of investment is to optimize the risk-return payoff through well-structured asset allocation. Since investors have different income level and risk tolerance, there is not a so-called “best” portfolio that fits everyone’s needs. Nevertheless, one concept is set in stone for asset management: diversification is the key to any investment portfolio.

So here comes the question: how to diversify a portfolio appropriately? In my view, it has to do with your understanding on the market reality, as well as on yourself.

Principle 1: History shows that risk and return are related.

Common stocks have clearly provided very generous long-run rates of return. It has been estimated that if George Washington had put just one dollar aside from his first presidential salary and invested it at the rate of return earned by common stocks, his heirs would have been millionaires more than seven times over by 1999. Roger Ibbotson estimates that stocks have provided a compounded rate of return of more than 8 percent per year since 1790. But this return came only at substantial risk to investors. Total returns were negative in about three years out of ten. So as you reach for higher returns, never forget that “There ain’t no such thing as a free lunch.” Higher risk is the price one pays for more generous returns.                                                                                                                                                                           ——A Random Walk Down Wall Street

I believe almost every investor has heard of this oldest theory in investment. The table below summarizes the risk-return relations for five major asset classes in the past century, in which small growth stocks have the highest, and U.S. Treasury bills have the lowest. The distinctive features of different asset classes make U.S. Treasuries the “safe-haven asset”, so investors usually pour a significant portion of funds into it for lower risk exposure when there are huge uncertainties in economic situation and market trend (i.e. Fiscal Cliff in 2013 & Yellen’s Speech last week).

                                                        Average Return       Average Risk Index

Small-company common stocks        12.7%                      33.9%

Common stocks in general                  11.0%                      20.3%

Long-term bonds                                   5.7%                        8.7%

U.S. Treasury bills                                 3.8%                        3.2%

Inflation rate 3.1

Source: Ibbotson Associates, Stocks, Bonds, Bills, and Inflation: 1997 Yearbook.

Nevertheless, a pure focus on low-risk assets such as treasury bills and long-term bonds tends to offer lower expected return. So the incorporation of stocks and derivatives is essential for capital growth.

Therefore, a good question to ask is “what is the percentage of each asset class in a diversified portfolio?” Let’s think about principle 2.

Principle 2: You must distinguish between your attitude toward and your capacity for risk.

The risks you can afford to take depend on your total financial situation, including the types and sources of your income exclusive of investment income. Your earning ability outside your investments, and thus your capacity for risk, is usually related to your age.

                                                                                                 ——A Random Walk Down Wall Street

As I mentioned above, there is not a “best” portfolio for everyone. A responsible asset manager has to execute investment decisions for a particular client based on the well-rounded mastery of his/her financial situation and beyond.

Personally, I interned at AIA Hong Kong office as a financial planner last summer. One of the tasks I accomplished was “financial health check interview”. The goal of the interview was to understand the financial status of clients and ensure their benefits from total protection. In the fact-finding stage of the interview, I collected financial facts, including income level, family expenses, aggregate debt, and investment style, as well as non-financial facts, including age, family status, diagnosed illness, and smoking & drinking habits. Through the integration of all these facts, I collaborated with my colleagues to develop a tailor-made financial solution spanning insurance, savings, and investment for each client.

In conclusion, a truly diversified and well-structured portfolio is not the result of a random selection from various asset classes in the market. Instead, it is derived from in-depth analysis on their features, as well as on your earning power and risk appetite.