The importance of asset class allocation
Underperformance raises the question, if the US Equity Growth Fund does not equal or beat the Russell 3000 Growth Index, what value has the investment management added to justify its fees? Simply buying the indicator is perhaps more beneficial.
Moreover, studies show that there is a significant correlation between returns earned by investors and the performance of the underlying asset class. For example, the overall performance of a US bond fund or portfolio is very similar to the Lehman Aggregate Bond Index, increasing and decreasing in tandem. This demonstrates that, since returns are expected to mimic an asset class, choice of asset class is much more important than market timing and individual asset choice. Brinson and Beebower concluded that market timing and individual asset selection account for only 6% of the variance in returns, with strategy or asset class making up the balance.
Breakdown of factors that account for variance in portfolio returns. Image copyright Sabrina Jiang © Investopedia 2020
Wide diversification across multiple asset classes
Many investors do not really understand effective diversification, often believing that they are quite diversified after dividing their investments across large, medium and small stocks; Energy stocks, finance, healthcare, or technology; Or even investing in emerging markets. However, in reality, they have only invested in multiple sectors of the equity asset class and are vulnerable to ups and downs with this market.
If we look at the Morningstar pattern indices or their respective sector indices, we will see that despite the slightly variable returns, they generally track together. Do not tend to see this synchronized directional movement. Therefore, it is only when positions are held across many unrelated asset classes that the portfolio is truly diversified and better able to handle market fluctuations, as high-performing asset classes can offset the underperforming classes.
The main gaps
There is a significant correlation between the returns that investors make on their holdings and the performance of the underlying asset class for those holdings.
True portfolio diversification is achieved through selecting and holding a variety of asset classes, rather than by picking out individual stocks and market timing.
Perfect asset allocation is not static. Asset performance and their relationships to each other change, so monitoring and reorganization are imperative.
Effective diversification will include asset classes with diversified risk profiles held in different currencies.
The hidden link between asset classes
An effectively diversified investor remains vigilant and vigilant because the relationship between categories can change over time. International markets have always been the key to diversification. However, there has been a marked increase in the correlation between global stock markets gradually in the late twentieth century and early twenty-first century. It began to develop among European markets after the formation of the European Union - in particular, the creation of the single European market in 1993 and the euro in 1999.5 During the first decade of the twenty-first century, emerging markets became more connected to the US and UK markets, reflecting the large degree of investment. And the financial development of these economies.
Perhaps most disturbing is the increase in what was originally an invisible link between fixed income and stock markets, which has traditionally been the mainstay of diversification of asset classes. The growing relationship between investment banking and structured finance may be the cause, but on a broader level, the growth of the hedge fund industry could also be a direct cause of the growing correlation between fixed income and equities as well as other smaller asset classes. For example, when a large multi-strategy global hedge fund incurs losses in one asset class, margin calls may force it to sell assets in all areas, generally affecting all other classes in which it has invested.
The bottom line
All too often, private investors get stuck picking stocks and trading - activities that are not only time consuming, but can also be stressful. It may be helpful - and less resource-intensive - to take a closer look and focus on asset classes. With this holistic view, the individual investor's investment decisions are simplified, and may be more profitable.