An abundance of research indicates that the structure of a diversified portfolio – its asset allocation – is the overwhelming factor in determining long-term returns. Stock-picking and market-timing have been shown to have relatively little long-term impact on a portfolio’s return.
Still, there are different approaches to portfolio management, and not all of them are asset allocation-centric. We’ll outline three primary approaches – the Traditional Approach, the Product Approach, and the Asset Allocation Approach – and describe the pros and cons of each.
The Traditional Approach
The Traditional Approach typically involves investing in 30 to 50 individual stocks and high quality bonds. Most often, the stock portfolio is heavily weighted toward “blue chip” stocks – large, successful U.S.-based companies. This “old school” approach is employed by many money managers and bank and trust companies as well as some traditional stockbrokers.
Advantages include simplicity, familiarity, and reasonable fees and costs. However, a relative lack of diversification means a lower expected return for any given level of risk. Also, the portfolio manager is often biased toward their own area of specialty (large-cap domestic equities, for example).
The Product Approach
Offering more diversification than the Traditional Approach, the Product Approach entails using multiple money managers and/or mutual funds and, in some cases, annuity wrappers, alternative asset classes and other structured products. The Product Approach is employed primarily by wirehouse brokers but also by some larger banks and insurance companies.
Advantages include sophistication and good diversification. However, this approach can lack customization, and it can be expensive, too, with higher fees resulting from active management and multiple layers of providers requiring compensation. Unfortunately, the objective of the Product Approach is all too often enhancement of the sponsor firm’s profit margin.
The Asset Allocation Approach
The Asset Allocation Approach focuses on overall asset allocation as the primary determinant of a portfolio’s expected return and risk. In following this approach, broadly diversified portfolios are constructed using cost- and tax-efficient strategies and investments. Most large institutional investors and investment consultants, as well as many independent wealth management firms, favor the Asset Allocation Approach.
Chief advantages are diversification at a reasonable cost, an optimal risk/return tradeoff, and customization to a client’s needs.
At Grand Wealth Management, we believe the Asset Allocation Approach is generally the most effective and prudent way to manage an investment portfolio. This approach may not, however, be for everyone. For investors who hope to “beat” the market, a well-diversified portfolio limits the opportunity to “place a winning bet” and profit from a large gain on a single stock or segment of the market. For other investors, a diversified portfolio’s exposure to all markets, including developed and emerging international market equities, may be outside their comfort zone.
But for investors who seek to balance risk and return and earn a return that reflects gains in all market segments, the Asset Allocation Approach is a good fit.