Important Things to Consider When Designing an Asset Allocation Portfolio

Asset allocation is an efficient approach to accumulate long term wealth from a highly diversified portfolio, and allows you to seek risk and return objectives without paying huge fees. To employ this diversification strategy, it’s beneficial to decide how to position your portfolio given available options. Given the plethora of exchange traded funds (ETFs) and index funds, building an asset allocation portfolio is fairly simple, but making sure your portfolio has the right mixture of assets is less straightforward. Consider these factors when deciding which asset classes to hold.

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 classes. These could then be partitioned by value and growth, or by sector creating more asset classes. Partitioning attributes such as size and style (growth and value) are known as factors. Fixed income asset classes can also be partitioned. For example, bond grade, duration and other metrics can be used to describe bond returns.

A good motive for subdividing an investments into more granular asset classes is to hold a different amount of holdings in each of the sub classes than what the parent asset class holds. For example, if you believe that growth equities will outperform value equities decrease your exposure to value. Within an asset allocation model, you would need to split equities by growth and value, and buy more growth to accomplish this.

Partitioning asset classes also pushes the efficient frontier upwards, providing greater diversification benefits. 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 increase the allocation to small cap equities to reduce portfolio risk, without sacrificing return. Structuring your portfolio with asset classes that don’t move in tandem reduces risk and increases returns, a cornerstone principle of modern finance. Partitioning yields more options and greater diversification value, but it also increases costs.

For a retail investor, managing more asset categories than necessary can be costly when transaction costs and taxes are tallied. When more asset classes are used more transactions occur, driving up associated costs. A balance needs to be struck between management costs and efficiencies gained from partitioning. A portfolio with 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.

We’ve found that 11 asset classes is a suitable number for individual investors looking to maximize diversification benefits, control risk, and keep costs in check. If you’re an active investors, you may want to position your portfolio to seek broader investments than 11. 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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