When many people hear the term "asset allocation," they immediately think of an efficient frontier diagram and the work of a pioneering economist.
A 25-year-old student at the University of Chicago back in the early 1950s, Harry M. Markowitz really needed a thesis topic. In a chance meeting, a stock broker suggested that he investigate the stock market.
At the time, conventional wisdom suggested that investors should pick stocks with the highest expected return rate, without taking risk into account.
Markowitz recognized that this approach neglected a key part of the investment equation. The concept of risk was identified as early as 1654 in the work of French mathematician Blaise Pascal, who worked on a system to determine probabilities related to gambling.
The concept of risk probability was then further studied by British astronomer Edmund Halley, who in 1690 applied it to mortality tables. Halley's work was later used to help sell annuities and insure sailing vessels and their cargos, which eventually led to the founding of none other than Lloyd's of London.
A Foundation for Success
But it was Markowitz who first rigorously applied the concept of risk to stock portfolios as part of his 1952 essay, "Portfolio Selection." His research found that diversification is measurably beneficial, and that pairing risky and less risky assets can actually lower portfolio volatility while simultaneously enhancing potential returns.
His early work laid the foundation for more sophisticated statistical concepts, such as mean variance optimization, which became integral to modern portfolio theory.
And for his efforts, Markowitz was recognized with the 1990 Nobel Prize in Economic Services, sharing it with Merton Miller and William Sharpe, both university professors.
While the term "asset allocation" is widely used to describe an investment strategy, it is actually a process.
Indeed, most investment professionals today use asset allocation as part of an overall approach to finances that involves identifying a client's current investments, risk tolerance, portfolio construction and asset selection, as well as measuring the performance of what they own and what, perhaps, they seek to buy.
The most time-consuming and analytical element of this process centers on asset-allocation modeling. This process involves analyzing hundreds of variables – such as long- and short-term economic forecasts; expected returns for different equity styles, sectors and capitalizations; standard deviation; as well as bond ratings and maturity structures.
Each portfolio combination is then tested for both risk and return characteristics.
But that's not the end of it!
These multi-asset portfolios are then monitored and adjusted in response to market conditions.
Some asset-allocation programs make adjustments at specific intervals (monthly or quarterly) back to a predetermined static allocation. And other asset managers reallocate assets on a daily basis, using a forward-looking process that is based on a longer-term allocation target.
Yet even as all this new work continues, one thing remains decidedly clear: Asset allocation will continue to be the foundation for many successful investment portfolios.
That's a lesson we all need to take to heart!
Craig Langweiler is president of the Langweiler Financial Group, in Newtown. He can be reached at 215-860-8066 or at: clangweiler@ americanportfolios.com.