Blog Post

Asset Allocation: Fundamental Principles

Part 1 - Benefits of Diversification



We often refer to our holistic, client-centered approach as a “mosaic” of related components that includes the players, their goals and their perspectives (“the people part”) along with the investment markets and their characteristics (“the money part.”) What is the bridge that brings these together? What ensures that these parts are complementary and work together effectively? We are referring to The Investment Process. This begins with the client and then moves along a path of activities that focus on a) the markets we invest in, b) the specific investments we select, and c) the evaluation of our results in the context of meeting the client’s financial goals.

The first part of the investment process is often referred to as “asset allocation” because it involves identifying the market segments where money (client assets) will be invested, or allocated. It’s essentially a blueprint of our investment strategy. But which strategy is appropriate? And how do we match the strategy to the client’s return goals and to their ability and willingness to bear risk? These are critical questions, as our answer will determine much of the client’s financial success.

In this series, we examine the asset allocation process, starting with understanding the value of diversifying effectively across the variety of investments, hoping to take advantage of opportunities to grow the client’s portfolio while minimizing uncertainty around the ups and downs of the markets. We will also examine the fundamental principles (and some of the mathematics) around how to combine assets so that we accomplish “double-barreled diversification” where returns are increased as risk is decreased. (Too good to be true? Stay tuned...) Using current forecasts of market returns, risks and diversification potential, we will create strategies that accommodate the client’s unique preferences, creating a truly customized approach to meeting their goals. Lastly, we will examine the idea of “efficiency” in practical terms, understanding how each part of the portfolio contributes to both return and risk.


We began our series with a foundation of a client-centered approach based on stewardship within a fiduciary context. This focused on meeting the client’s monetary goals, which are funded by their investment portfolio. We balanced their current capital with the expected withdrawals by identifying the required return on the investments. We also examined the effect of the volatility of expected returns, since higher levels of volatility increase the likelihood of “mission failure,” where the portfolio cannot continue to support required withdrawals without depleting its capital.

This process showed us that client monetary goals are tied to the investment goals of return and risk. Our first building block of the investment portfolio’s risk and return is our asset allocation process. The output of this rigorous process is a return and a level of volatility risk that are the result of market exposure. This exposure can be delivered through low-cost passive products that mimic the investment markets (“index funds”) or through actively-managed products that seek to earn higher returns without incurring additional risk. Our initial focus is simply on drawing the investment blueprint; subsequent articles will address the most appropriate way to implement the investment plan.


The asset allocation process begins with a set of market opportunities that are described by their expected returns, volatility risk and the relationship between all pairings of assets, using the correlation statistic. These are forward-looking estimates of what we might expect over the long term (typically the next 10 – 15 years.)

We’ve organized these market segments into three broad asset classes: bonds, equity and alternative investments. These are global in nature and are also quite granular and detailed. We see that the boundaries of risk vs return are marked by lower volatility/lower return bonds one on end, and higher volatility/higher return equity on the other end. Between these two we see the set of alternative investments, which have characteristics of both bonds and equity.

These capital market assumptions include 58 options. That’s both “good news” and “bad news” because:

  • some of these segments overlap, violating the principle that our options should be unique; when you violate this guideline, the result is confusion (this is what mathematicians call “co-linearity;”)
  • there are too many choices: our 58 options create over 1,600 unique pairings.


To get a clearer idea of the behavior of the major asset groups, we equally-weighted the segments within each asset class. This gives us an average value for risk and return for each of the three larger groupings. (Behind the scenes, this is also evaluating the relationship between each of the segments within the three groups, as seen in the correlations between their segment pairings.) This graphic is an unbiased, simpler version of the scatter plot of all 58 asset segments.

This confirms our sense of the risk and return characteristics of the major asset classes. Our goal is to achieve our target return without taking on too much risk. Our asset allocation process will include two types of diversification:

  • within each asset class
  • across asset classes.


We begin by taking a simple and intuitive approach to creating our asset allocation. Our first step is to establish an acceptable mix of segments within each asset class. This selection process depends on the suitability of each of the segments, which is determined by a number of factors, some of which are a bit subjective. These may include familiarity, market outlook, and fit within our own constraints and preferences. Clearly, this is not an “optimization” approach - that will come later! In spite of our intuitive approach, the results are actually quite efficient in terms of the tradeoff between return and risk.

This graph shows return and risk for the segments we’ve selected; they are the “list of ingredients” for our asset portfolios.

Our straightforward asset allocation process is to combine these asset segments to create three broad asset classes. We can then allocate money to these three “portfolios” (bonds, stocks, alternatives) to produce the set of strategies that accommodate a variety of client return goals and risk tolerances.

Our bond “portfolio” has a core position of Aggregate bonds, which include intermediate-maturity Treasury and corporate bonds, along with the securitized segment of home mortgages, commercial mortgages and asset backed securities (home equity loans, car loans and credit card receivables.) We squeeze out a bit more “juice” (in terms of yield) by adding longer-maturity Treasuries and high yield bonds, with credit ratings below the high quality bonds of the rest of the portfolio. We then add non-US bonds of both developed and emerging countries.

The equity portfolio diversifies across size in the US, and adds stocks of the developed and emerging economies of non-US countries.

The alternatives portfolio is split evenly between real estate (REITS) and private equity.


We often hear investment commentators refer to the “60-40” portfolio that allocates 60% of its assets to the S&P 500 index, and 40% to the Aggregate Bond index. The appeal of this approach is its simplicity, familiarity, liquidity, low cost and reasonable amount of diversification. Many investors consider this to be a decent “starting point” for a diversified strategy.

With that in mind, we created a set of strategies using these two assets, starting with an allocation of 50% in each, and then increasing the equity allocation up to 100 percent. This is our “2-Asset Portfolio.” It is our “baseline” for diversification.

Our second step was to increase diversification in our domestic portfolio by adding mid and small-sized US stocks, plus long Treasuries and high yield bonds. This is our “6-Asset Portfolio.” It increases long-term return by about 30 basis points, relative to the 2-Asset strategy. It’s significant to note that the 50-50 allocation of our 6-asset strategy earns a 6.6% return with 9.4% risk, while the less-diversified 2-asset portfolio requires a more aggressive 70-30 equity/bond allocation to deliver that same return. Even then, its volatility is 11.7% (a relative increase of over 12 percent.) That’s a clear example of the value of increasing diversification to achieve a target return with less risk.

Next, we “go global” by adding a pair of foreign assets to the bond and to the equity allocations of the 6-Asset Portfolio. The effect of adding global assets is even more significant than diversifying the domestic stock and bond asset classes. The average increase in return of the global portfolio (vs the diversified domestic portfolio) was an additional 55 bps, in a range of 30 - 85 bps. Its steeper return-vs-risk line shows that the reward for taking additional volatility risk increases substantially as the investor reaches for higher returns.

Our final diversification step is adding alternative investments. The benefit from this is somewhat more modest, but still meaningful at an average of 25 bps, in a range from 10 – 40 basis points. This is to be expected, given that alternatives share characteristics of both bonds and equity. Adding alternatives also lowers risk slightly as it increases returns.

It is striking that the most conservative global portfolios outperform the 100% equity portfolio that’s invested only in the S&P 500 – and they deliver this return with only 55% of its volatility. We also see that the 12-asset strategy outperforms the 2-asset strategy by between 60 145 bps (from the most conservative to the most aggressive strategies, after adjusting for slightly higher levels of volatility.) That is the power of diversification!


We’ve established a foundation that confirms the idea that diversification is a critical aspect of investment success. While a thorough and robust approach is required, the process need not be overly complex or involved. We demonstrated that the most important decision is to include market segments that represent the variety of opportunities available to investors. It is more important to spread our wealth across the globe, while being mindful to include complementary assets in our mix. The goal is to have assets that offset each other’s periods of weakness, so that smoother, less volatile returns are the result.

We’ve seen the benefit of increasing the number of distinct segments within each major asset class. Creating well-diversified asset classes allowed us to develop different allocations to the relative safety of bonds and to the growth opportunities in global equities and alternatives. Our “tiers of diversification” demonstrated the significant benefit from each successive level of broader asset exposure. Our process was rigorous, yet understandable and highly intuitive.


  • What about the mathematics of diversification? What insights will this reveal?
  • What about “optimization” and using the other 45 asset segments that weren’t included in this initial analysis?
  • And what about “portfolio efficiency?” How do we avoid concentrations of risk, making sure that the all of the segments in our strategies contribute equally to both return and risk?

This is a lot of ground to cover, and we will build on our initial insights as we examine these interesting and useful topics.

Written in partnership with Stephen Campisi