Asset allocation is the centerpiece of any investment plan, whether it's for an individual or an organization. People typically set their asset allocation based on traditional assumptions -- many of which may be badly out of date in today's unusual financial environment.
Here are four examples of how today's extreme conditions are rewriting the rules of asset allocation:
1. Don't count on time being the solution to stock volatility
Financial consultants have traditionally pitched the idea that while the stock market may have extreme ups and downs from year to year, that this type of volatility tends to smooth out over the long term. However, with the S&P 500 hovering at around 1,400 as of early August, it was still below its level of 12 years earlier.
When it comes to stocks, time doesn't heal all wounds. This means that people can't be so complacent about their risk levels or return assumptions, even if they have several years to go before retirement.
2. Bond yields almost guarantee lower-than-average returns
It used to be that you could count on bonds for a solid 6 percent or so a year, simply because of their income yields. Now, with 10-year bonds yielding less than 2 percent, historical return assumptions need to be radically rethought.
True, interest rates might rise, but the nature of bonds is that their principal value usually falls when interest rates rise. This makes it virtually impossible for conventional bonds to get back to their historical return levels over the foreseeable future. The return assumptions embedded in many asset allocation programs -- and retirement savings assumptions -- need to be reworked.
3. Savings account rates provide stability, but little else
Savings account rates, along with rates on similar cash-related vehicles such as money market accounts, have taken an even deeper hit than bond yields. The good news is that unlike bonds, savings and money market accounts cannot decline in value, so savings account rates can benefit right away if interest rates rise. The bad news is that, in the meantime, don't expect cash accounts to provide you with much of anything except stability.
4. Diversification does not guarantee safety
Diversification is a sound principle -- spreading your money around into different types of investments can reduce your risk. However, it does not eliminate risk, and in an increasingly interdependent world, there may be a diminishing benefit to diversification.
For example, foreign stocks were once hailed as a way to diversify away from exposure to the U.S. economy. Back when international trade was a much smaller portion of the global economy, individual economies were much less interdependent.
Today, though, international trade and finance have grown to a level where most major economies often rise and fall together -- as was clearly demonstrated in 2008. The lesson is that diversification might help smooth out routine fluctuations, but under extreme conditions your risk level is likely to depend very much on the overall economic exposure of your holdings.
In the past, asset allocation principles have often been used to put a portfolio on a form of auto-pilot: The thinking was that if you followed the rules, you'd end up with a normal rate of return over the long run. Now that so many market norms have broken down, it may be time to rethink this auto-pilot approach.