Asset Allocation: Balancing Risk and Reward

You have heard the cliché, “There’s no such thing as a free lunch.” But you may be less familiar with Nobel Prize laureate Harry Markowitz’s quote, “Diversification is the only free lunch” in investing.

Markowitz is best known for his pioneering work in modern portfolio theory (MPT), studying the effects of asset risk, return, and diversification on investment portfolio returns. Hundreds of books have been written about portfolio diversification and asset allocation. To put it simply, the key to diversification is using more assets. The less correlation among those assets, the better.

A mainstay of asset allocation has been the 60/40 portfolio: 60% in stocks and 40% in bonds. This type of portfolio is more than adequate for most investors. Over the last 50 years, a 60/40 portfolio has delivered an annualized return close to 10%[1]. However, if you are using only U.S. stocks and bonds to build a portfolio, you are using only a fraction of the available investment universe.

Institutions, foundations, and generational wealth think of their capital as permanent, and can invest in more asset classes than a traditional 60% equity, 40% bond portfolio. Diversifying assets include, but are not limited to international markets, infrastructure, real assets, hedge funds, and private equity and credit. Combined with equities and bonds, these reduce overall risk through diversification. These investments are not low risk as stand-alone strategies, however, their risk reduction properties come from the power of low correlation to one another in diversification.

Based on our long-term, strategic asset allocation, we build portfolios that can withstand different market environments. Strategic asset allocation requires establishing allocation targets for each asset class and setting assumptions for risk tolerance, investment goals, and time horizon. Our asset allocation targets vary from balanced 50/50 portfolios, to traditional 60/40 and more aggressive 90/10 portfolios.

On the other hand, tactical asset allocation works by actively shifting portfolio allocations to take advantage of market trends, economic conditions or perceived mispricing opportunities in asset classes or investments. For example, the Investment Committee decided last year to reduce the core bond allocation to below the strategic allocation weight and to increase the weighting to Treasury Inflation-Protected Securities (or TIPS) due to concerns over inflationary pressures as the economy reopened.

Rebalancing requires that investors maintain the discipline to follow the process. This can be challenging in volatile markets. Rebalancing means buying stocks in periods of market stress and economic uncertainty. It may also entail reducing stock exposure during periods of strong market returns when investor sentiment is bullish.

Your Sendero portfolio is built with purpose. We are intentional about using assets that create diversification and we can measure the impact. As a reminder, the broad purposes of the portfolio are:

  • Stability — This allocation is intended to reduce the volatility or risk profile of the overall portfolio. These investments should be liquid, low volatility and provide income (i.e. cash, cash equivalents and bonds). Inflation and a negative or rising rate environment are the biggest threats to this asset class.
  • Growth — This allocation is intended to reflect opportunities from economic growth and innovation. Growth assets (i.e.: stocks) are expected to have higher appreciation, volatility, and risk profile than other allocation segments. An early business/market cycle is an attractive time to add to growth assets. Later market cycles may still be attractive but the risk of a slowing economy impacting corporate profits may limit potential returns.
  • Diversifier — This allocation is intended to improve overall return and risk characteristics of the portfolio by investing in strategies with low correlations to stocks and bonds. Diversifier strategies may trade long and short markets, invest in currencies, interest rates, commodities, futures, real estate, and other less marketable securities. Often strategies require a lock-up period of investor capital.

Your portfolio is meant to be invested during different types of markets. In equity bull markets, it is easy to forget the need for diversifiers, however markets do go down!  Pandemics, wars, and other macro events can’t be predicted but your portfolio needs to be prepared for such events. If you have any questions or want to have a conversation about the market or your portfolio, please contact Liz, Ed, Fred, Scott, Tyler, or myself. Your Sendero team is ready to help. 

Best Regards,
Amaury de Barros Conti

[1] The Asset Allocator’s Edge, P. Huber, page 18.