Sound Advice: January 25, 2023

Why Asset Allocation?

Asset allocation is a fancier way of describing diversification.  For Wall Street purposes, it’s a variation on “don’t put all your eggs in one basket.”  That phrase is the bottom line for what’s known as Modern Portfolio Theory.  Sounds complicated, but it’s nothing more than the reality that in the world of Wall Street, all investments do not always move in the same direction.  In fact, with rare exception, their paths of progress differ considerably. 

Equities, more familiarly known as stocks, move up and down in reflection of the trend of profits of the underlying companies.  When business is good, companies make more money and stocks go up.  And vice-versa.

Fixed-income holdings, most of which are bonds, rise and fall in price in response to changes in interest rates.  When rates are rising, the prices of most fixed-income investments will fall.  In the U.S., interest rates are largely controlled by the Federal Reserve Board as part of its ongoing effort to keep the economy on an even keel.  At best, this is a difficult exercise.

The Fed aims for a target inflation rate of 2%.  When the pace of inflation slows, typically along with a moderation in economic growth, the Fed will lower rates in the expectation that a lower cost of money and easier credit will stimulate business.  When inflation rises, as it has recently, the Fed raises rates to put the brakes on demand.

More often than not, stocks and bonds have moved in opposite directions, so portfolios with holdings spread in both areas have enjoyed greater stability.  Last year, however, rising rates hurt both of these investment sectors.

From a portfolio construction perspective, it still pays to have holdings in both, though it’s equally important to take a closer look at the details.  In the area of stocks, there’s always a choice between growth and value, i.e., rapidly growing companies at higher valuations vs. slower growing, more reasonably valued companies.  For most of the past decade, growth was the better choice.  Last year, value was a clear winner.  While the economy is sputtering in the months ahead, that trend may continue, but as business recovers growth may regain its footing.

Then there’s the matter of domestic vs. international.  As the dollar has gained strength, thanks to rising interest rates, international investments have slipped.  After rates peak and then ease, that pattern will change.

Returns from fixed-income investments are tied to the length of the holding periods.  When the economy is growing, yields rise as the holding periods lengthen.  The chart of yields rising as periods lengthen is known as a normal yield curve.  When the economy is sputtering, higher yields are usually found when maturities are shorter.  That’s what we have now.

Taking all of this into account, the goal is to diversify sufficiently to maintain the potential for worthwhile gains over time while keeping risk within tolerable levels. 

N. Russell Wayne, CFP^Ò

Sound Asset Management Inc.

Weston, CT  06883

203-895-8877

 

www.soundasset.com

www.soundasset.blogspot.com

 

Any questions?  Please contact me at nrwayne@soundasset.com