Important things to consider when constructing an asset allocation portfolio
Asset allocation is an excellent way to build long term wealth from a highly diversified portfolio, and allows you to seek risk and return objectives cost effectively. To utilize this diversification approach, you'll need to decide how to structure your portfolio given asset class options. Given the plethora of exchange traded funds (ETFs) and index funds, building an asset allocation portfolio is fairly straightforward, but making sure your portfolio has the right mixture of assets is less straightforward. Here are some factors to consider when deciding how to choose asset classes for your portfolio.
An important attribute to consider is that asset classes are nested. For example, equities can be partitioned into US equity, developed international equity and emerging markets equity. US equities can be further partitioned by size, into small cap, mid cap and large cap, making 3 more asset classes. These asset classes could then be partitioned by value and growth, or by sector creating more asset classes. These partitioning attributes such as size and style (growth and value) are known as factors. Professionals use factors to describe asset returns. MSCI Barra uses 68 different factors to explain equity returns. Partitioning can also be applied to fixed income. Duration, grade and other metrics are often used to categorize fixed income investments.
A good motive for subdividing an asset class into child asset classes is to hold a different proportion of money in each of the sub classes than what the parent asset class holds. For example, if you feel that growth equities will outperform value equities underweight value. Within an asset allocation model, you would need to seperate growth and value, and buy more growth to accomplish this.
Partitioning asset classes also allows you more options by which to diversify your portfolio, pushing the efficient frontier upwards. As an example, if small cap equity becomes uncorrelated with commodities and real estate, and large cap and mid cap do not, then you may want to overweight small cap equities to reduce portfolio risk, without sacraficing return. Structuring your portfolio with asset classes that don't move in tandem reduces risk and increases returns. Partitioning asset classes yields more options and increases expected returs, but it also increases costs.
For a retail investor, using more asset classes than necessary can be costly when transaction costs and taxes are tallied. When more asset classes are used more trading occurs, resulting in increased transaction costs and taxes. A balance needs to be struck between management costs and efficiencies gained from partitioning. Using more asset classes provides greater opportunity to control risk and take advantage of uncorrelated positions, or potential alpha factors, but there are diminishing returns as more partitions are made, and the cost of management increases.
Balancing the benefits of diversification and risk control with management costs, we've found that 11 asset classes provide an excellent core portfolio. If you're an accredited investor, you may want to position your portfolio to seek broader investments than 11 asset classes. If you do intend to make active market bets you might take a look at the core-satellite framework to structure your portfolio. This framework will help you organize your portfolio into active market bets and your core portfolio, designed to provide diversified market exposure.
An important attribute to consider is that asset classes are nested. For example, equities can be partitioned into US equity, developed international equity and emerging markets equity. US equities can be further partitioned by size, into small cap, mid cap and large cap, making 3 more asset classes. These asset classes could then be partitioned by value and growth, or by sector creating more asset classes. These partitioning attributes such as size and style (growth and value) are known as factors. Professionals use factors to describe asset returns. MSCI Barra uses 68 different factors to explain equity returns. Partitioning can also be applied to fixed income. Duration, grade and other metrics are often used to categorize fixed income investments.
A good motive for subdividing an asset class into child asset classes is to hold a different proportion of money in each of the sub classes than what the parent asset class holds. For example, if you feel that growth equities will outperform value equities underweight value. Within an asset allocation model, you would need to seperate growth and value, and buy more growth to accomplish this.
Partitioning asset classes also allows you more options by which to diversify your portfolio, pushing the efficient frontier upwards. As an example, if small cap equity becomes uncorrelated with commodities and real estate, and large cap and mid cap do not, then you may want to overweight small cap equities to reduce portfolio risk, without sacraficing return. Structuring your portfolio with asset classes that don't move in tandem reduces risk and increases returns. Partitioning asset classes yields more options and increases expected returs, but it also increases costs.
For a retail investor, using more asset classes than necessary can be costly when transaction costs and taxes are tallied. When more asset classes are used more trading occurs, resulting in increased transaction costs and taxes. A balance needs to be struck between management costs and efficiencies gained from partitioning. Using more asset classes provides greater opportunity to control risk and take advantage of uncorrelated positions, or potential alpha factors, but there are diminishing returns as more partitions are made, and the cost of management increases.
Balancing the benefits of diversification and risk control with management costs, we've found that 11 asset classes provide an excellent core portfolio. If you're an accredited investor, you may want to position your portfolio to seek broader investments than 11 asset classes. If you do intend to make active market bets you might take a look at the core-satellite framework to structure your portfolio. This framework will help you organize your portfolio into active market bets and your core portfolio, designed to provide diversified market exposure.
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