Differentiating Asset Allocation and Diversification

portfolio-makeupAny 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.

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Risk Analysis of TIP Portfolio – 1H09

Any long term investor will know that they need to manage risk in their portfolio. The way individuals should manage their risk is asset allocation and diversification. Today, I am discussing how I manage risk in our income portfolio. The objective of this risk analysis is to make sure that TIP portfolio is not exposed to any particular event, or company, or any other aspect that will affect portfolio performance.

My portfolio management process has a risk management process in which I try to:

  1. Maintain pre-determined asset class allocation;
  2. Maintain pre-determined diversification, any sector should not exceed 10%;
  3. Any single stock should not exceed 7% of the portfolio;
  4. Dividends from a single stock should not exceed 5% of total dividend cash flow.

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Portfolio Risk Management – It’s More Than Just Asset Allocation

Every financial literature and tutorial has drilled into our brains that asset allocation is one of the basic fundamental tenets of portfolio management. Financial publications, peer-reviewed literature, and books have observed that asset allocation is the significant contributor to the total return. This contribution factor  varies anywhere from 50% to 95% depending upon how the data is analyzed with reference to timescale, markets and asset coverage, dividends, inflation, and what not parameters.

What intrigues me is following two issues:

(1) Look at any historically successful and well known investors in US, e.g. Buffet, Lynch, Ross, Pickens, etc., and one will find that none of them followed asset allocation principles. In fact they were highly concentrated in few businesses or companies. E.g. Buffett’s portfolio shows 10 companies represent 85% of the portfolio. Continue reading rest of this article…