Multiple-Asset-Class Investing

By M. Isi Eromosele

Today, we talk about asset allocation rather than diversification, but it is really just a new name for a very old and time-tested investment strategy.

A more contemporary translation of an old advice might read: “Let every investor create a diversified portfolio that allocates one-third to real estate investments, one-third to common stocks, with the remaining one-third allocated to cash equivalents and bonds.

Is this still a good idea today? The overall portfolio balance is one-third fixed-income investments and two-thirds equity investments. The one-third allocated to fixed-income mitigates the volatility risk inherent in the two-thirds allocated to equity investments.

Diversification across two major forms of equity investing with dissimilar patterns of returns further reduces the equity risk. The result is a balanced portfolio, tilted toward equities, appropriate for an investor with a longer investment time horizon who is simultaneously concerned about risk and return. It is a remarkably elegant and powerful asset allocation strategy.

New capital markets are forming, and investment alternatives have proliferated. People from around the world can exchange volumes of information instantaneously via the Internet, virtually without cost. The world has truly gotten smaller and increasingly interconnected as economic events in one part of the world affect markets on the other side of the globe.

In spite of all of this change, investors are not that different today than they were a hundred years ago. They want high returns, and they do not want to incur risk in securing those returns.

Diversification is a time-honored investment principle. Let’s explore the role of multiple-asset-class diversification in giving investors the returns they long for, while mitigating the risks they face.

Global Investing

When we construct an investment portfolio using multiple asset classes, we discover that portfolio volatility is less than the weighted average of the volatility levels of its components.

This occurs as a result of the dissimilarity in patterns of returns among the components of the portfolio. We will call this advantageous reduction in portfolio volatility the diversification effect.

Multiple Asset Class Investing

The equity side of the portfolio is usually responsible for great portfolio returns when they occur. The equity side of the portfolio is also most often responsible for significant losses.

When comparing the returns of 15 equity portfolios, we find that single-asset-class portfolios generated three out of the four lowest returns, whereas the highest returning portfolios were mostly multiple-asset-class structures.

When we compare the volatility levels of these portfolios, we find that four out of the five most volatile portfolios were single-asset-class structures. The low volatility alternatives are all multiple-asset-class portfolios.

We often cannot see the beneficial impact on return created by broader diversification because diversification examples mix fixed-income investments together with equity investments. In this situation, the large difference between the returns of fixed-income and equity investments obscures the increase in portfolio return attributable to the diversification effect.

Because the longer-term rates of return of the four equity asset classes used in our analysis were fairly similar, we can see the positive impact diversification has on both dampening volatility and increasing return.

Why Isn’t Everyone Doing Multiple-Asset-Class Investing?

If multiple-asset-class investing is so wonderful, why isn’t everyone doing it? There are three primary reasons.

First, investors lack an awareness of the power of diversification. The typical investor understands that diversification may reduce volatility, but suspects that diversification simultaneously impairs returns. As have been demonstrated, diversification tends to improve returns, not diminish them. Investors need to be educated about this dual benefit.

Second, the question of market timing arises. Investors naturally want to believe that there must be some way to predict which asset class will come in first place. And some money managers suggest that they, in fact, can accurately make such market timing predictions, a dubious claim at best.

The third reason involves investor psychology. Investors use their domestic market as a frame of reference for evaluating their investment results. For example, a U.S.-based investor will compare his equity returns with a market index such as the Standard & Poor’s 500 Stock Index.

This frame of reference is not a problem in years when the U.S. market underperforms other asset classes, because diversification into better-performing markets rewards a multiple-asset-class investor. When the U.S. market comes out on top, however, the investor perceives that diversification has impaired his returns. This sense of winning or losing arises primarily from the investor’s immediate frame of reference.

Each year, the multiple-asset-class strategy loses relative to some of its component asset classes and wins relative to others. That is the nature of diversification. The problem with diversification is that it works whether or not you want it to.

Equity investing is a long-term endeavor. Investors should devise and implement strategies with the long term in mind. Investors naturally attach more significance to recent investment experience than to longer-term performance, but they should resist the temptation to abandon more diversified strategies in favor of chasing yesterday’s winner.

Investors prefer predictability to uncertainty, and they face a menu of investment alternatives differentiated according to their levels of volatility. The buying and selling activity of investors establishes security prices that bring supply and demand into equilibrium.

For this to occur, more volatile asset classes generally will have higher expected returns than less volatile asset classes. This leads to competitive, risk-adjusted returns across investment alternatives.

The diversification benefits of a multiple-asset-class approach rest on the dissimilarity in patterns of returns across investment alternatives in the short run and competitive asset pricing in the long run. These conditions should hold in the future, even in the face of risks and opportunities that are unique to our times.

M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance

Copyright Control © 2012 Oseme Group