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Whither Asset Allocation?

Shelly K. Schwartz,|Special to CNBC.com
Monday, 24 May 2010 | 12:32 PM ET

There’s been no shortage of speculation over whether asset allocation strategy still works.

Indeed, the process of diversifying one’s portfolio across a variety of asset classes was put to the test during the 2008-2009 market meltdown. And the outcome wasn’t good.

Investors who had dutifully spread their eggs among multiple baskets and stayed the course, a.k.a. buy and hold, watched helplessly from the sidelines as their retirement accounts lost a collective $2.8 trillion between the market peak in October 2007 and the trough in March 2009, the Center for Retirement Research at Boston College reports.

“There was a lot of talk that diversification models were broken and for a short period of time there was some validity to that,” says Elliot Herman, an investment advisor for NFP Securities in Quincy, Mass.

Asset allocation, of course, is predicated on the premise that investors can limit downside risk by owning a mixed bag of non-correlated securities, like stocks and bonds, which historically move in opposite directions during any given market cycle.

“You saw large-cap and small-cap stocks, international and domestic all going down together—the good stocks with the bad,” says Herman. “Buy and hold was challenged, I think in response to clients just wanting to do something. They believed this time was different.

For some, tactical asset allocation, a more active portfolio management strategy that seeks to time the market, became the alternative of choice.

Yet, hindsight brings wisdom. Now a year into a convincing market recovery, many in the financial community say standard asset allocation is still the key to the kingdom for average investors.

It just needs a little tweaking—and, perhaps, another test—this time from the European debt crisis.

Brett Hammond, for example, chief investment strategist for TIAA-CREF, still recommends an all-weather portfolio of 60 percent stocks and 40 percent fixed income, or cash, for investors during their accumulation years, depending on age, risk tolerance and financial circumstances.

New Asset Classes

But he emphasizes the importance of incorporating new asset classes to capitalize on market swings.

“We very much believe in alternative investments, but you don’t want to overdo it,” says Hammond, noting a 10 percent allocation towards alternatives such as private equity, emerging market bonds, hedge funds and real estate, is a good starting point for most investors.

You can adjust higher or lower depending on your circumstances.

Hammond notes alternatives can be more risky and tend to be less liquid, so they’re better candidates for investors who can afford to let their portfolio ride through all market conditions.

Changing Times

Herman of NFP Securities agrees retirement planners these days should employ a hybrid approach that incorporates alternative investments as basic building blocks of their portfolio.

While he once recommended a split of 80 percent equities and 20 percent fixed income for younger investors, Herman now says he might suggest that same investor put 65 percent into equities, 20 percent into fixed income (divided between credit sensitive and investment grade bonds) and the remaining 10 percent to 15 percent in non-correlated securities like real estate investment trusts, REITs.

Shelter from the Storm
Finding safety in emerging markets, with Daniel Tenengauzer, BofA Merrill Lynch Global Research and Andy Busch, BMO Capital Markets.

As investors approach retirement, he says, they can consider reducing their equity exposure by 5 percent (to begin with) and allocating towards guaranteed income products instead, such as immediate annuities, which creates a stream of income during retirement.

“The same rules apply today as they did before the crisis in many ways,” says Herman. “We feel strongly that the average investor can and should embrace the new offerings of absolute- return funds and hedge fund-like strategies for a portion of their portfolio.”

Absolute-return funds seek to produce a positive return in all market conditions by owning unconventional assets, which are not permitted in traditional mutual funds, such as futures contracts, options and derivatives. They also employ investment strategies such as short selling and arbitrage.

Under the alternative asset umbrella, says Kevin Gahagan, a principal with Mosaic Financial Partners in San Francisco, commodities can play a valuable role in the average investor’s portfolio, since they help hedge against inflation.

For those looking to gain exposure, but unsure how to break into the market, he notes, commodity index funds are a good point of entry.

Just make sure the fund is widely diversified, rather than industry-specific, which tend to be more volatile.

Keep Cash Separate

Though cash holdings are paramount for all long-term savers, Herman notes it should not factor into your investment portfolio until you reach retirement.

“Cash liquidity is important but that’s something you need to maintain outside of your portfolio” he says.

If the set-it-and-forget-it investment approach has lost its appeal since the Great Recession, as it has for many, there’s one way to become more tactical with your portfolio without treading too close to the slippery slope of market timing—rebalance on a regular basis.

Over time, especially during volatile markets, the market’s ebb and flow will deliver varying returns for the assets in your portfolio, throwing your target allocation out of whack.

The best way to rebalance is to sell a percentage of your best performing stocks or bonds, and put the proceeds into asset classes that are now underweight.

“I’m in favor very much of standard asset allocation,” says Hammond. "These days you want to review your portfolio once a year. You may not want to make any changes, but you want to review it.”

You can also dampen the effects of volatility by practicing dollar-cost averaging, says Hammond, the tried and true strategy of buying into the market at regular intervals—thus ensuring you buy some of your stocks low and some of them high.

In today’s turbulent market, it’s more important than ever to stick with asset allocation models that stand the test of time.

Likewise, says Hammond, Main Street investors who are considering more risky market timing strategies need to remember to keep their eyes on the prize.

“If you’re saving for the long run, what you’re really trying to do is create an income for yourself in retirement,” he says. “A lot of times people forget that. The advice out there says you want to maximize your returns and create wealth, but that’s only a means to an end and the end is creating financial security in retirement.”