Asset allocation — the percentages of your portfolio that you hold in different types of investments— is critical to investing success. A well-designed asset allocation that is adjusted periodically for changing circumstances can significantly reduce risk and increase returns.
Yet too many investors somehow believe it's a good idea to design their allocations using a tired old template and then let them languish. This approach can easily result in disappointing returns because it doesn't account for changes in risk in asset classes (eg., stocks and bonds) over time. As these risk vary, why shouldn't your asset allocation?
Investors who cling to this extremely passive approach are confusing myth with reality, and their notions about asset allocation are right out of the Land of Make-Believe.
Here are some of the most persistent — and pernicious — myths about asset allocation, and the corresponding realities.
Myth: A good allocation always follows this formula: 100 minus your age, the remainder being the percentage of your total assets that you should have in stocks. So if you're 50 years old, you would have 50 percent of your portfolio in stocks, 40 percent in bonds and 10 percent in cash. You should gradually adjust your allocation over time to reflect your growing age and thus, your stocks-to-bonds ratio. But you stick with the formula.
Reality: This was your grandfather's asset allocation. For decades, it has been recommended by financial advisors and repeated endlessly in books and articles. Think about the lunacy of this approach: It assumes everyone who is the same age should have the same allocation regardless of their individual circumstances.
Myth: Widely respected research into the role of asset allocation in pension fund portfolios shows that these allocations accounted for about 90 percent of their returns over the long term. This implies active management (stock picking) doesn't really matter—if you just allocate properly everything will be peaches and cream.
Reality: The 90 percent figure is incorrect. The actual number according to studies could be drastically lower, between 16.5 and 40 percent! The 90 percent figure was a misinterpretation that went viral from the marketing efforts of financial services companies that opportunistically seized on it of an easy-to-understand investing panacea.
Some researchers concluded that about 60 percent of performance outcomes in these funds had resulted from other factors — including investment managers' making changes regardless of whether they comported with the asset allocation (active versus passive management), the individual securities they selected within each asset class and the impact of fees. These numbers suggest that assuming your asset allocation will do all the work for you can be like fiddling while Rome burns.
Myth: An unchanging asset allocation will always protect your portfolio from loss because the values of different asset classes always move in different directions.
Reality: In times of market crisis, the benefits of diversification can disappear or are greatly diminished.
Myth: Time heals all wounds, so a well-constructed asset allocation, left unchanged, will protect you from risk over the long term.
Reality: That may be true — if there's enough time. But we are mortal, so we invest in mortal time frames. Failing to keep this in mind can lead you into the time horizon trap.