The world is filled with recommendations and research on what works best in the money game. But when you reduce the sea of study down to the essential lessons, we’re left with rule number one—diversify within and across asset classes, i.e., asset allocation—and number two—rebalance.
There are other rules, of course, and some of them are actually useful. But for most individual investors, and perhaps many institutional investors, these two rules are the foundation of intelligent money management. That’s another way of saying that it’s hard to succeed in investing if we ignore or abuse these rules.
Granted, it’s possible to violate these rules and still earn big returns. But finding success on this path requires that you’re smarter than everyone else and/or willing to take big risks that will sink most investors. For the rest of us, asset allocation and rebalancing are the building blocks of prudent investing. Intelligent investing needn’t end there, but it’s a valuable beginning.
That’s good news in the sense that it streamlines the investing process. We can certainly go beyond these two rules, but it’s not necessary. If you have reasonable investment goals and a time horizon that extends forward over several business cycles, asset allocation and rebalancing are likely to satisfy.
Of course, that’s assuming you make informed decisions on diversifying the portfolio and managing the mix intelligently through time. It’s not necessarily rocket science, but it does take some thought, a fair amount of discipline and healthy respect and understanding of market history. Ideally, you’ll also make routine projections of return and risk for the major asset classes. In The Beta Investment Report, we regularly forecast equilibrium risk premiums for the major asset classes. This isn’t a silver bullet, but it’s a productive beginning because the process provides a neutral reference point for thinking about long-term market returns. In turn, that gives us some context for deciding how to second guess Mr. Market’s asset allocation for the intermediate term.
The reasoning behind asset allocation and rebalancing starts by recognizing that owning a mix of asset classes taps into the benefits that flow from holding assets that don’t move in lockstep with one another at all times. As powerful as this force is, it fluctuates in the short term, as last year reminds. In other words, asset allocation is only a partial solution. We also need to rebalance the asset allocation, which further enhances the odds for success in generating risk-adjusted returns that satisfy our long-term goals.
At a basic level, rebalancing is simply buying asset classes that have stumbled and selling those that have done well. For most investors, rebalancing should be marginal but continual. Sharp, sudden changes in the asset allocation, in short, should be avoided. Instead, continually rebalancing at some fixed interval–or opportunistically if you’re so inclined–will provide a good deal of the benefits.
The value of asset allocation and rebalancing is self evident. A careful analysis of the full range of asset classes tells us so. For example, over the past 3 years, the range of returns is quite wide, as you can see in our monthly updates on asset classes on these pages and in our more in-depth reviews in The Beta Investment Report.
Tapping into the enduring tendency for different asset classes to dispense varying results is the essence of why asset allocation is a critical piece of investing. Alas, most investors are woefully underdiversified. Simply fixing this oversight and owning a wider array of assets will likely enhance results over the long haul. The next step is harnessing the rewards that come from exploiting the fluctuations in the major asset classes and their principal subgroups. Overall, a simple rebalancing strategy will capture the lion’s share of these rewards for most investors when measured over several business cycles.
Yes, we can go beyond asset allocation and rebalancing. We can even do much more detailed analysis on these bedrocks of investing strategy. But for most investors, focusing on these two aspects of portfolio management in an uncomplicated way will reap rich rewards. Accordingly, paying too little attention to asset allocation and rebalancing carry big risks.
In short, Pay close attention to designing and managing the asset mix. Much of the world practices a far more complicated form of money management, but that doesn’t mean that greater complication leads to better results.