Asset Allocation Theory
Asset Allocation Theory: What is asset allocation? Asset allocation is essentially a form of risk diversification. The ideal is to find investment classes that are not correlated with one another in any way. While this is not necessarily possible, the next best alternative would be to find investments that have low correlation with one another.
Asset Allocation Theory
The theory of asset allocation relies on several basic concepts:
- First, that diversification significantly reduces the possibility of a large loss.
- Second, that diversification can be achieved through low correlation between asset classes. However, correlations between asset classes change overtime and can even reverse.
- Third, that annual rebalancing of a portfolio would help control risk. This relies on the basic theory of regression to the mean, a theory which assumes that all investments have a certain risk and return profile, and that they will eventually fall in line with these natural tendencies over time. Rebalancing may seem counter-intuitive, as it would mean selling high and buying low – hence adjusting for overly optimistic or overly pessimistic prices in the market.
History of Asset Allocation
Asset allocation began from the work by Harry Markowitz from the University of Chicago. In his paper, he argued that financial risk is a desirable component of portfolio management, as it leads to high rates of return.
He also argued that portfolio risk can be controlled through the proper diversification of investments, and that the risk of individual investments are relatively unimportant compared to the way all the investments work together to reduce overall portfolio risk.
Markowitz later developed his theory further to what is now known as the Modern Portfolio Theory. This theory explained the mechanics of efficient asset allocation, and soon became highly popularized. Now, the MPT methodology can be easily followed by making use of various free basic asset allocation softwares available on the Internet.
Modern Portfolio Theory: The Free Lunch
In the asset allocation theory, the free lunch refers to the fact that if one can diversify across many dissimilar investments and rebalance them annually to adjust for price fluctuations, the annual volatility of the portfolio will be reduced while returns will be increased – thus the ‘free lunch’.