Rules of the Game: Asset Allocation

 | Jul 18, 2013 | 9:00 AM EDT
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For years, when I was a growth-stock trader, I bought into the notion that proper use of technicals and market timing were the only things necessary to grow wealth in the stock market. Among the particular crowd I was associated with, Modern Portfolio Theory (MPT) was something to be mocked and incorrectly termed "buy and hold."

These days, I've become an MPT convert. When helping our clients stay retired, it's really not a good idea to be trading in and out of Green Mountain Coffee Roasters (GMCR) or Proto Labs (PRLB). Instead of betting that chart patterns will yield the hoped-for results (based upon absolutely no empirical research, just anecdotal occurrences), it's wiser to construct portfolios using various asset classes, and based on expected returns.

In recent columns, I have been discussing risk. One key factor of investing risk is the "randomness of returns." What does that mean? Over the short term and the long term, asset classes behave differently. That sounds pretty obvious, but the idea is brought home by not focusing solely on the S&P 500.

Sure, that's a popular index of large-cap U.S. stocks, and our clients have exposure there. But it's impossible to know which years the S&P will be up or down. Most investors would throw in the towel at that point, rationalizing that "it's impossible to beat the market." Either that, or they would put on their trading hats, and try to figure out which stocks will outpace the index. (As if that mattered, but that's another topic, for another day.) 

But there are other investments besides the S&P. Diversified portfolios combining various investments can smooth out choppy returns. Given the U.S. financial media's obsession with the S&P 500 and the DJIA, it can be easy to overlook the myriad investing opportunities.

But data clearly show that other assets perform well when U.S. large-caps are languishing, and vice versa. Portfolios that incorporate various investments are tailored to weather extreme returns.

But what traders with a "beat the market" mentality don't realize: Investors seeking to accumulate wealth for their non-working years must be willing to accept fluctuations in their investment value today. Historically, stocks have tended to offer higher returns, but with greater fluctuations in value than fixed-income investments. Understanding the long-term behavior -- i.e. fluctuations -- in various asset classes may help investors manage expectations and develop corresponding strategies. 



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