Asset Allocation – What it Is, Why it is Important

Author: John Rothe | Posted: 06-09-2007

For many people. Asset allocation means diversification. However, it is not as easy as buying four separate mutual funds and allocating 25% of each mutual fund -this not what true asset allocation is.

True asset allocation is based on the principals in Modern Portfolio Theory (MPT). In 1952, Harry Markowitz wrote a thesis that showed proper diversification in a portfolio will lower risk, (or volatility) per a given unit of reward. Markovitz later went on to be presented the Nobel Prize in Economics for his work based on this thesis.

Why is this important? Simply put, it allows an investor to optimize a portfolio for the level of risk he or she is comfortable with, while providing guidance on what level of return should be associated with that risk. Separate asset classes correlate differently with each other. A mutual fund that invests in technology companies is going to perform in a different manner than a fund invested in US Treasury bonds.

For example, a mutual fund invested in equities will carry more risk than a US Treasury bond. Overtime, the mutual fund should provide an investor a greater return than the bond, since it is taking on more risk, thus a greater reward.

This idea becomes the backbone of the efficient frontier. The efficient frontier allows an investor to find the point where maximum return can be achieved for a level of risk (referred to as standard deviation.

By using the efficient frontier, one will be able to optimize a portfolio to maximize return at a risk level comfortable to an investor.