Asset Allocation Models

Independent, academic studies¹ show the most important decision determining your longer-term portfolio performance is asset allocation—the mix of stocks, bonds, cash and other securities you select. We believe about 70% of your longer-term return ties back to this very choice, although some sources argue the share is higher. Given this, we believe portfolio modeling must begin here—selecting an incorrect asset allocation model (too high a share of bonds or cash, too much in stocks, deviating to illiquid assets) is very common and may be a damaging investment error. In our view, there are two broad asset allocation model categories:

• Strategic Asset Allocation is your baseline allocation model, a mix chosen because it has return and risk characteristics targeting longer-term goals and objectives. As such, we believe correctly crafting strategic asset allocation must start with identifying your needs, your goals and your objectives. A key aspect is time horizon —how long you need the portfolio to work to achieve those goals. (Note the difference between that and how long until your retirement.) Strategic asset allocation has nothing to do with current market conditions and everything to do with your needs. Your portfolio positioning should generally start from this strategic asset allocation.

• Tactical Asset Allocation is how the mix of stocks, bonds, cash and other securities shifts based on an expectation of broad market conditions. Bull markets (a period of prolonged rising stock prices) and bear markets (a lasting, fundamentally driven decline of more than -20%) are the most commonly known. While no one will be perfect calling a bear market—ourselves included—we believe a defensive strategy, if successfully implemented, is designed to sidestep some of its negativity.

Tactical asset allocation modeling aims to take advantage of our forecast. If we believe an equity bear market will not strike in the next 12-18 months, we’ll likely invest according to your strategic asset allocation. In our view, this should be how you invest the vast majority of the time. However, if we forecast a bear market, we’ll likely temporarily cut equity holdings relative to your strategic asset allocation. This is an effort to sidestep some of the expected decline in stocks, with a goal of re-entering stocks at lower prices.

Increasing equity exposure in your portfolio boosts expected returns and volatility in the short term. But over the longer term, an interesting phenomenon occurs: Equity returns stay higher than bonds, but standard deviation falls. This means equity returns over the longer term are more consistent than bonds—counterintuitive but true.

1. Brinson, Beebower and Hood, 1979.