Any investor investing for long term (i.e 10+ years) must use the principles of asset allocation and diversification in their portfolio management process. These are two aspects that help investors to manage risk of investments. This has been said many times, presented many times, and we individual investors still continue to make mistakes. On a personal front I have been guilty of it in recent past. Both asset allocation and diversification are two different aspects and hence they have different objectives. The primary reason individual investors get exposed to downside risk is because many are unable to differentiate between these two aspects.

Asset allocation is a strategy of allocating capital to different types of assets which are either non-correlated or at least have low correlation. The notion here is that, over time, the volatility in returns will smooth out if they have low correlations. The different types of assets that I am discussing here include, cash, government bonds, corporation bonds, common stocks, preferred stocks, real estate, private equity, natural resources, commodities, partnerships, etc.

In general, many studies in different parts of the world, it has been shown that there is low correlation between stocks, bonds, real estate, and natural resources.

Furthermore, many studies have also shown that there is relatively higher correlation between style of investing (i.e. growth, value, blend) and market capitalization (i.e. small cap, mid cap, large cap). These correlations range from 0.7 to 0.96 (1.0 being perfect correlation and 0.0 being no correlation).

What this means is, if a long term growth or value investor invests in companies with different market capitalization, even then the investor is not getting any asset allocation benefits. The investor is likely getting diversification benefits only. Diversification helps manage risk from the view of sectors, industry, and investing style alone. This does not provide asset allocation benefits.

The issue with diversification is such that it not easy to truly understand how to execute diversification. There is no simple straight forward method to design a portfolio which has high diversification. Investors blindly assume that investing in different sectors, industries, companies, etc, will provide diversification. That is misconception exposes them to downside risk.

Asset allocation and diversification are tools for portfolio risk management. However, both have different approaches and implemented in different ways. It is unlikely that at a beginning, we may not have all assets. However, based on individuals risk profile, it can be built over time.

Many investors cite Buffett’s philosophy on concentration as a way to critic the concept of diversification. However, BRK’s portfolio exhibits pretty high diversification. Using Monte Carlo Simulation and Theory of Portfolio, Buffett’s portfolio shows Diversification Metric 67% (100% being best). This is based on only 20 stocks in BRK. This DM is expected to increase by approximately 3% to 4% if all of his holdings, approx. 60, are including in this calculation.

It can be argued that all these discussions of asset allocation and diversification can be tossed out based on what’s happened in 2008 and continuing in 2009. However, investor’s need to realize that investing is a long term process. The two or three years is a very small time period and does not reflect the true benefits of the asset allocation and diversification. In addition, portfolios that are based on these two principles would have had less downside risk.

Over the course of next few days, I will present two portfolios (Harvard Endowment Fund and Yale’s Endowment Fund) as an example to show how they use asset allocation in their portfolio management process.

asset allocation, diversification, portfolio management, risk