Asset Allocation and Diversification

There is a lot of research on how much of the typical returns of funds are from Asset Allocation and how much are from performance of individual asset. The general consensus is that "Asset allocation determines the majority of returns". Some researchers put it to the extent of 90% of the returns. Wow! Is that true? Does it mean that the individual stock portfolio construction is useless? Also, is there a logical basis to justify the above fact?

A related question is about the composition of individual portfolios. What are the typical assets that an individual investor should have and in what proportion? Is this a completely subjective matter or are there any broad rules to decide that.

Let us talk about the first question first, is asset allocation necessary. If yes, why?

A book that talks about this in a logical manner, is Harry Browne's Fail-Safe Investing, in which he proposes four different types of economic scenarios and also proposes four different asset classes to do well in each of those scenarios. Browne talks about Growth, Depression, Inflation and Deflation as those four scenarios.

1. Growth :- When the actual demand for goods is increasing and inflation is under control or low, the phase is known as growth in the economy. In this care, the real GDP per capital shows increase.
2. Depression :- Opposite of growth. The overall demand for things goes down.
3. Inflation :- The actual demand for goods is stable or growing very slowly but the prices of goods is increasing rapidly. In other words, the real GDP per capita is stagnant but the nominal GDP per capita is growing.
4. Deflation :- Opposite of inflation. The demand for goods may be stable but the prices are going down.

Browne asserts that these are the only possible scenarios and an investor needs to do reasonably well in each of them. He proposes Stocks for growth, Gold for inflation, Cash for deflation and Bonds for Depression. He goes on to propose an equal asset allocation(25% in each) to do well in the long run without volatility in the portfolio.

Similar reasons can be constructed from multiple points of views but essentially you need asset allocation to weather the business cycles while withdrawing money from your invested portfolio. This prevents you from needing to sell your stocks at an absolute bottom, erasing all the gains that you have made.

The counter point for asset allocation is made by people who insist that concentration yields better returns since it is followed by one's conviction and the energy to track the portfolio is conserved by the low number of asset classes.

One can try various approaches and stick to the one that works for both rational and emotional conviction of the investor.

The emotional conviction is very important when we deal with the second question. Even when one is convinced that a certain allocation is good for one in the long run, it is difficult to stick to that asset allocation because of the volatility in the portfolio. Some people propose the proportion of assets on the "Sleep well " principle. It simply states that you should have the asset classes that enable you to sleep well in the night in spite of the wild gyrations in the portfolio.

So, the driving factors to determine the type of assets, their proportion and withdrawal, depends on understanding of the assets, bandwidth to track the various assets and emotional energy to face the ups and downs in the portfolio and stick to an asset allocation framework.

Disclaimer :- None of the above should be considered an investment advice. Please talk to an investment advisor when you are taking a decision.