Asset allocation is a cornerstone of modern portfolio theory. Most financial planners swear by it. They claim spreading investments across stocks, bonds, and other asset classes reduces risk while optimizing returns. But I’ve found that rigid asset allocation strategies don’t always work. In some cases, they can even hurt performance.
Table of Contents
The Traditional Case for Asset Allocation
Before critiquing asset allocation, let’s understand why it’s popular. The idea comes from Harry Markowitz’s Modern Portfolio Theory (MPT). MPT suggests that by combining uncorrelated assets, investors can achieve higher risk-adjusted returns.
The expected return of a portfolio E(R_p) is calculated as:
E(R_p) = \sum_{i=1}^n w_i E(R_i)Where:
- w_i = weight of asset i
- E(R_i) = expected return of asset i
The portfolio risk (standard deviation) \sigma_p is:
\sigma_p = \sqrt{\sum_{i=1}^n \sum_{j=1}^n w_i w_j \sigma_i \sigma_j \rho_{ij}}Where:
- \sigma_i, \sigma_j = standard deviations of assets i and j
- \rho_{ij} = correlation between assets i and j
This math suggests diversification lowers risk. But reality is messier.
When Asset Allocation Fails
1. Correlations Converge During Crises
In normal markets, stocks and bonds often move independently. But in crashes, correlations spike. During the 2008 financial crisis, nearly all asset classes plunged together. Diversification provided little protection.
| Asset Class | 2008 Return |
|---|---|
| S&P 500 | -37.0% |
| Corporate Bonds | -4.5% |
| Commodities | -36.6% |
| Real Estate (REITs) | -37.3% |
If correlations approach 1, the diversification benefit vanishes:
\sigma_p \approx \sum_{i=1}^n w_i \sigma_i2. Over-Diversification Dilutes Returns
Adding too many assets can lead to “diworsification.” Warren Buffett once said, “Diversification is protection against ignorance. It makes little sense if you know what you are doing.”
Consider two portfolios:
- Portfolio A: 100% in a high-conviction stock with 15% expected return.
- Portfolio B: 10 assets, each with 8% expected return.
Even if Portfolio B has lower risk, the opportunity cost may not justify it.
3. Static Allocation Ignores Market Cycles
A 60/40 stock-bond split worked well for decades. But in a low-yield, high-inflation environment, bonds drag performance. From 2000-2020, the 60/40 portfolio delivered ~6% annualized returns. A 100% equity portfolio returned ~7.5%.
Alternative Strategies
1. Tactical Asset Allocation
Instead of fixed weights, adjust allocations based on market conditions. For example:
- Reduce bonds when yields are near zero.
- Increase cash during overvalued equity markets.
2. Risk Parity
Allocate based on risk contribution rather than capital. The goal is to equalize risk across assets:
w_i \sigma_i = w_j \sigma_j \quad \forall i,j3. Concentrated Portfolios
Some investors (e.g., Buffett, Munger) prefer holding a few high-quality assets. The Kelly Criterion helps optimize position sizing:
f^* = \frac{bp - q}{b}
Where:
- f^* = fraction of capital to bet
- b = net odds received
- p = probability of winning
- q = 1 - p
Behavioral Pitfalls
Investors often chase past performance, leading to poor timing. A study by Dalbar Inc. found the average investor underperformed the S&P 500 by ~4% annually over 20 years due to bad allocation shifts.
Final Thoughts
Asset allocation isn’t useless—it just isn’t a one-size-fits-all solution. Blindly following a fixed allocation can be worse than having no strategy at all. I recommend a flexible approach:
- Stay diversified, but not dogmatically.
- Adjust for macroeconomic shifts.
- Focus on risk management over rigid rules.
The best financial planners know when to deviate from textbook asset allocation. And sometimes, the best move is not to allocate at all.
