The (Real and True) Benefit of Active Asset Allocation: Part 1August 21, 2019
What exactly makes active asset allocation an important part of creating and balancing your investment portfolio? We explore here.
We are often challenged by potential clients as to the true value of active asset allocation, suggesting instead that a target asset allocation simply be pre-determined and then left alone, essentially ‘set it and forget it’? Since asset allocation is the real value proposition behind active investment management, the true message behind this challenge is ‘why should I pay for something I don’t want and I don’t need? This is indeed a fair question and I will address it below.
What is active management?
Also called active investing, this is a portfolio management strategy where the manager makes specific investments, aiming to outperform an investment benchmark index or target return.
What is the value proposition?
Just to review the basic premise behind the value proposition, let me reprise part of my April Monthly Market Update . Using stocks, the ‘riskiest’ of the three major financial asset classes, as a base context, the three levels of active management are –
- How much total (of an aggregate portfolio) in stocks?
- What kind of stocks? – U.S. vs International, Large Cap vs. Mid/Small, Growth vs. Value
- Which stock(s)?
Let me further refine the context to that of an investor, whether it be an individual or an entity, with what I call ‘Core Wealth’, defined as wealth that has been hard-earned and hard-accumulated over time and, crucially, is intended to benefit the current owners and/or those to follow for a very long time. It cannot afford to get knocked off a long term track.
As noted in that April Update, the relative contribution of the three levels is roughly 75-20-5% of comparative performance. Indeed the relative impact of the last level –“Which stock(s)?” – can be almost fully diversified away and is therefore only worth ‘paying up’ just a little for. Since correlations among all stocks are reasonably high, I will agree that ‘paying up’ for this second level should also be only incremental.
How is the long term track for “Core Wealth” maintained?
The rubber really, really meets the road at that first level. The ‘how much in stocks’ has always been, and will always be, the huge determinant of whether that long term track for Core Wealth is maintained, or not. Yes, we’ve been in a very long bull market, now well into its 11th year. Many Wall Street pundits – though I am not among them – argue for its strong continuance well into the decade of the ‘20s. Let me note that the ‘challenge’ expressed has over the years been very much a product of long-term bull markets, when every immediately-prior decision to re-balance away from stocks to bonds/cash has in hindsight proven to be wrong. Furthermore, the cash-on-cash return from bonds/cash is essentially at an all-time low.
It won’t always be that way, though. With market averages at all-time highs in mid-July, 2019, it is easy to forget the mini-bear market in stocks that occurred only three calendar quarters ago. The broad averages fell 20% but many stocks fell considerably more than that. Though I could certainly be wrong, I’ve seen in my career a number of instances where such moves, materializing almost overnight and seemingly out of nowhere, proved to be ‘a shot across the bow’, with an even more severe decline in terms of magnitude and time, lying ahead.
In Part 2 of this blog, stay tuned for how a flexible and active approach to asset allocation can provide significant value as a portfolio adjusts between greater or lesser participation in stocks.
Questions? Reach out to KLR Wealth Management, LLC.