- Money Morning Australia

Why Allocation Beats Diversification

Written on 12 October 2011 by Kris Sayce

Why Allocation Beats Diversification

In today’s letter we’ll show you the single, most important financial advice you’ll read this year. Advice that will help you prepare for – and survive – the ongoing financial volatility.

Because make no mistake, the market action you’ve seen since 2007 will continue. How long it will last is anyone’s guess. But think about it. Four years ago few thought the market would be where it is today… and it doesn’t look like things will get better any time soon.

If that’s enough to make you close this email and go do something else… STOP. Keep reading. We’ll explain why in a moment.

But first…

Media and Financial Blackout

Your editor has just come back from a 10-day family holiday to the Gold Coast. It was the first proper holiday we’d had since July last year.

This time, with everything going on in the financial markets we decided this wasn’t going to be a working holiday. There would be no watching the Aussie stock market… no staying up til midnight watching the U.S. markets open… and no wireless Internet access to check the latest stock, bond and currency prices…

It was a total media and financial market blackout.

Do you know what, we coped just fine. We went to the beach, we went to theme parks, we went for walks… we had breakfast, lunch and dinner… all of it without once looking for or thinking about share prices and foreign exchange rates. We didn’t even care about the gold price.

We lived like most of the Aussie population. Just like those who either don’t care or don’t know what’s happening in financial markets. And let’s be honest, most people wouldn’t know Dr. Ben S. Bernanke from a bar of soap.

Here’s the important thing. While it was nice to be ignorant of the markets for a while, it’s not much of an investing strategy. And it’s a pretty poor wealth protection strategy too.

But that’s how most folks deal with their wealth.

Why is that? It’s because they’ve fallen for the trick that investing is hard… that it’s so hard you should leave it up to someone else to look after. (And don’t get us started on the welfare state, “The government will look after me…” argument.)

The thing is wealth planning isn’t that hard if you know what to do…

The importance of allocating your wealth rather than diversifying it

We like Dan Denning’s note in the August issue of Australian Wealth Gameplan:

“…I’m going to show you a share market asset allocation model aligned with my world view. It’s a simple way to split up your financial assets in four categories… Just because it’s ‘the end of the financial world as we know it’ doesn’t mean you can stop thinking about how to preserve and grow your wealth.”

Dan says asset allocation is the most important part of investing. We agree. But when most people think of asset allocation they just think about investing in different shares – a few banks, a few resources stocks and a few retailers… “That should do it”, they think.

But Dan makes the point:

“A well-designed portfolio is a unified strategy, not a bunch of separate punts.

“You could take a bunch of separate stock picks and chuck them in a spreadsheet and call them a portfolio. But it would be no such thing. In a real portfolio, each position has a specific weighting… The various positions in the portfolio work in concert to try and produce the desired return with a certain level of risk.”

But here’s the key: asset allocation doesn’t just mean diversification. The conventional wisdom among most investors is you should spread your wealth across many assets – shares, property, bonds, etc. And once you’ve done that, that’s it. You do nothing else.

We disagree with conventional wisdom. Investors should take a “world view” of their assets and adjust them over time.

Put another way, using an asset allocation approach rather than a plain vanilla diversification approach, you’re actively managing and adjusting your wealth based on where you believe markets and economy is heading next…

Rather than just choosing a bunch of stocks and hoping for the best.

In short, diversification is a lazy, passive and ultimately doomed way of managing your wealth… while asset allocation is a thoughtful, activity and as Dan says:

“According to the famous Brinson Study… asset allocation has a bigger influence over the performance of your portfolio than stock selection or market timing. Get the asset mix right, and you’ve done the really important work.”

It’s a small but important difference.

Asset allocation means more work. But long term, if you want to build wealth rather than see it eroded in a volatile market, putting in the small amount of extra work is vital.


PS. If you’d like to know Dan’s thoughts on asset allocation in more detail, we’d suggest you take a few moments to read this free special report

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Kris Sayce
Kris is never one to pull punches when discussing market developments and economic events that can affect your wealth. He’ll take anyone to task — banks, governments, big business — if he thinks they’re trying to pull a fast one with your money. Kris is also the investment director for Australian Small-Cap Investigator, Diggers and Drillers and Revolutionary Tech Investor. If you’d like to more about Kris’ financial world view and investing philosophy then join him on Google+. It's where he shares investment insight, commentary and ideas that he can't always fit into his regular Money Morning essays. Read more about Publisher and Investment Director Kris Sayce.

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2 Comments For This Post

  1. M&M Says:

    Another way of thinking about it, is that some of us specialise in our chosen careers and that is how we do better than the average wage / do better than the market.

    Specific stock picking and timing (if you can) will produce best returns.

  2. janet Says:

    Diversification is really saying ” I don’t know what to do”. Put your assets into 100% of one thing…and just see how much it makes you concentrate! It also make you much more alert to risk, and ‘taking a loss’, if your wrong, is much easier if you know that by not being willing to admit it quickly, you could lose the lot!

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