Opportunistic Asset Allocation

Asset allocation has been elevated to a science, although as the bear market of 2008-2009 showed, it failed to protect investor portfolios from devastating losses. Yet the basic tenets of asset allocation are sound: don't put all your eggs in one basket and spread your money across several classes of assets with limited correlation to reduce overall portfolio volatility.

Academics are the biggest proponents of asset allocation, and financial planners and wealth managers are its most devout practitioners, using "proper" allocation percentages as a selling point of their "expertise." But does it really matter whether you are holding 19% in small cap stocks and 8% in foreign bonds or 21% in small cap stocks and 6% in foreign bonds?

The idea of asset allocation must have come from somewhere other than college campuses. If you look at the portfolios of successful investors, you may find different classes of assets: government bonds and small cap stocks, junk bonds and utility stocks, or municipal bonds and large caps - whatever the case may be. But that does not mean that you should go out and buy every asset category based on some "scientific" formula suggested by your financial planner.

How, then, should you do asset allocation?

The answer is opportunistic asset allocation. You limit your exposure to any one asset class no matter how compelling the potential or historical returns are so that you always have cash for the next investment opportunity. You don't know where or when one will present itself, but the key is not in knowing or forecasting but in being ready to act.

Periodically, a temporary market dislocation may create an exceptional investment opportunity. It may be in U.S. government bonds, commodities, or large cap stocks - you never know. But you take advantage of the opportunity by investing a portion of your money in it and holding the stake as long as it is making you a profit.

If you take a snapshot of an opportunistic portfolio such as this, it may hold different types of assets at different times, providing a strong case for asset allocation. But if you analyze the dynamics of it, you may find out, for example, that at some point the portfolio only held a bunch of small cap stocks, then foreign bonds were added when they presented a good investment opportunity, then some of the assets were shifted into large cap stocks because they began to outperform small caps, and so on. Asset allocation and its percentages were constantly changed to reflect changing investment opportunities but at no time was it artificially split among all investment classes based on some academic formula.

More from this contributor:
Asset Allocation Won't Protect Your Portfolio in a Downturn
Cash Management and Dynamic Asset Allocation for Active Stock Traders
Private Equity: Another Bubble in the Making?