Asset Allocation and the Efficient Frontier
What is Asset Allocation?
Asset allocation is a technique that determines the mix of asset classes (small stocks, big stocks, emerging markets, government bonds, corporate bonds, etc) that provides the highest probability of achieving a given return rate. For example, if you need a return of 12.2%, asset allocation might result in a mix of 40% large stocks, 40% government bonds, and 20% emerging markets. You should achieve the maximum rate of return for the least amount of risk at a given level of risk.
Asset allocation is different from security selection, which is the process of selecting the securities you will actually invest in for each asset class. For instance, choosing to put 40% of your portfolio in long-term growth stocks is an asset allocation decision; choosing to buy 100 shares of ATT stock is a security selection decision.
Why Perform Asset Allocation?
Diversification lets you cut risks sharply without sacrificing return. Of all the decisions an investor makes, effective, or optimal asset allocation has the greatest effect on your total return. Optimal asset allocation distributes a portfolio’s assets so that there is an optimal tradeoff between risk and return.
Several studies have shown that your asset allocation decision is the most important factor affecting your long-run risk and return. In fact, 93% of long-term performance results from asset allocation. The specific choice of securities accounts for only 7% of long-term total performance.
The Efficient Frontier Graph
There are many possible asset allocations. The optimal asset allocations are calculated along a line graph using expected returns, standard deviations, and covariances of each asset class to plot what is called the efficient frontier graph. The efficient frontier represents those portfolios that provide the maximum expected return at each incremental level of risk.
Levels of investment risk are determined by your time horizon, investment philosophy, and age. The key to successful investing is finding the asset allocation that offers the best possible return without exceeding your tolerance for investment risk.