Asset allocation is the method by which you choose various financial instruments to achieve financial independence. Have you ever wondered how to build a solid and profitable investment portfolio? It’s a question I’ve been asked many times. It’s not as complicated as you might think.
All you need to do is understand the three pillars that we will explore together in this article.
We’ve already discussed the difference between strategic and tactical asset allocation. The former, strategic allocation, will make the difference in your long-term results. Asset allocation involves dividing the percentages of each financial asset within your investment portfolio. This decision is one of the most important you will make in your investing career.
Personally, it took me many years and a lot of reading to reach my conclusions and define my investment strategy (strategic asset allocation). However, at this time, I consider it premature to illustrate my investment composition. For now, it’s more useful to outline the decision-making process. At the end of this series of articles, I will be happy to show you my portfolio.
Risk & Return in Asset Allocation
The first two pillars for building a solid foundation are: risk and return. Although economics is a social science, in this case, the rules governing it are physical. Remember that as return increases, so does risk, even if you don’t see it at first. I assure you, it is true. If a bond has a 10% return, it is very risky, more than your financial advisor might want you to believe. Remember, in finance, there are no free lunches.
There is no free lunch
It was the American economist Harry Markowitz, Nobel Prize winner in Economics in 1990, who revolutionized the world of investments with his Modern Portfolio Theory MPT. He mathematically demonstrated what every investor seeks: the trade-off between risk and return through diversification. His portfolio theory won the Nobel Prize because it identified the so-called efficient frontier which maximizes return for a given level of risk.
Typically, risk is measured using volatility. Volatility, in simple terms, is the measure of price variation, for example of a stock, over a specific period of time. If a price fluctuates very quickly and frequently within a short span of time, it is said to have high volatility.
The Concept of the Mean
It’s not all. Volatility should not be analyzed in absolute terms but relative terms. It should be measured against the historical average of a series of data, such as stock prices that vary from the average of those data over time. High volatility relative to the average means that the data fluctuates significantly around the average, while low volatility indicates greater stability in the data relative to the average.
The mean in finance is a statistical variable that is very important. Always remember that everything that goes up eventually comes down. This phenomenon is known as: mean reversion. We will see in future articles how I use this important indicator to shape my asset allocation, choose my investments, and what information it can provide us.
Time
To complete our decision-making process and attempt to make the right choice that will define our asset allocation, we must consider one final variable, the third pillar: time.
As John Bogle, known as “Jack,” taught us, time is your friend. If you allow me, I’d like to add a qualifying adjective to this statement: “better.” Brief introduction for those who may not know him: Bogle was the founder and CEO of The Vanguard Group. As passive investors, we all owe him a debt of gratitude, as he made index funds popular.
Time is your best friend
In the next article, we will analyze major market crashes (bear markets) to understand why this statement might surprise you.
On avance !
