Feb. 15, 2013— -- 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.
For example, if you use the classic formulaic allocation based on 100 minus your age and you're 60 years old, you would have 40 percent of your assets in stocks and 60 percent in bonds. This hefty a bond allocation may have been fine for a 60-year-old in 1985, when the bond market was growing apace.
But now that bonds are in a bubble and inflation may rise, this allocation could substantially reduce your retirement resources if a lot of these bonds have 20 years until maturity and are paying rates that may not keep up with the rate of inflation.
Just because the classic allocation formula dictated keeping a given slice of your assets in bonds years ago doesn't necessarily mean this is a good place to be now. Many investors fail to consider the time horizon trap when setting up their asset allocations. They love to refer to sound bites from professionals like Warren Buffett who is often quoted saying his favorite holding period is "forever."
But Buffett's firm, Berkshire Hathaway, isn't a person. Rather, it's an institution with an infinite time horizon because it has no set life span and no need for retirement resources.
Unlike an institution, when you're retired, you're no longer adding to your nest egg. Instead, you're probably decreasing it to pay expenses. Asset allocation is an important piece of your investment strategy. But it's not the Holy Grail. You should periodically reevaluate your allocation based on what's happening in the markets and the risks you may be facing in reaching your retirement goals.
Failing to do so can lead to disaster. The set- it-and-forget-it mentality is like putting your portfolio on cruise control and then pulling a Rip Van Winkle. If you decide to travel down this road, ignoring the hazards of each asset class, you could awaken in 20 years to find out that you only dreamed that your retirement planning was on track and that it's actually stuck in a ditch.
This work is the opinion of the columnist and in no way reflects the opinion of ABC News.
Craig J. Coletta has 20 years of experience in the financial industry. He is president of C.J. Coletta & Co., a Registered Investment Advisor firm, and president of Coletta Investment Research Inc. Coletta is a Chartered Financial Analyst charterholder, a Chartered Market Technician and a Certified Hedge Fund Professional. He holds a B.S. in accounting and business administration from Rider University, and is a member of the American Institute of Certified Public Accountants.