Up until a few months ago, asset allocation and diversification were unappetizing ideas. For several years, the upside action was in a select group of large-cap growth and dot-com stocks.
But starting in early spring, hard-hit stocks and mutual funds in the foreign, small company and value arenas made a powerful recovery. For the first time in years, some of these asset categories gained favor against their technology and blue-chip rivals. Meanwhile, the market's former darlings started to turn. And asset allocators breathed a collective sigh of relief that their approach was again appealing.
Lost in this preoccupation with the popular market averages was the fact that asset allocation isn't a strategy for delivering abundant returns. "I tell clients that it doesn't guarantee they'll get better performance," says Mike Hines, president of Consolidated Planning Corp. in Atlanta. But until somebody invents a workable crystal ball, asset allocation remains an investment staple.
The idea of spreading dollars among various investment categories--in a manner that reflects a person's age, risk tolerance, liquidity needs and other factors--makes intuitive sense. It also has held up to tests of academic scrutiny as a means to reduce volatility.
"People need to stick with a discipline and keep investing in assets that are underperforming," says Jim Pupillo, a wirehouse broker in Scottsdale, Ariz., and past president of the Institute for Investment Management Consultants. "But thank God for this year's rally because even I was getting tired of hearing myself repeat that."
It's during such periods that brokers earn their pay by keeping portfolios properly diversified. Of course, that's easier said than done. Hines says he lost a couple clients prior to this spring's rally because of allocation disagreements. "They wanted to pull all of their money out of bonds and anything else that wasn't large growth stocks," he says. "The problem from our point of view is managing client expectations."
Pitching UnderperformanceAny way you slice it, successful allocation strategies rely on your ability to sell clients on the idea of sticking with--and even adding to--underperforming asset classes.
The best time to start this difficult task is at the beginning of a relationship. "We explain our philosophy up front, and if someone remains on the fence, they won't become a client," says Keith Goldner of Gibson Capital Management in Pittsburgh.
Assuming a new client accepts the diversification premise, you need to reinforce allocation principles. "You have to explain that if a portfolio is properly diversified, you'll always have some asset that's underperforming," Pupillo says.
Review with clients past cycles and yearly performance figures to see how different investment styles have gone in and out of favor (see "Growth Versus Value Stocks," Page 84). "It's like having a wardrobe with more than just winter clothes," says Tom Ruder, an Edwards Jones broker in Evansville, Ind.
For example, large growth stocks have been on a multiyear roll lately, but do clients know that these current darlings barely kept up with returns on certificates of deposits during the first five years of the decade? Until recently, small stocks and foreign shares lagged badly, yet both categories have enjoyed prolonged periods of sizzling gains in the past.
"I tell people that if I was good at predicting which assets would be hot tomorrow, I'd be on an island with a laptop trading for my own account," says George Fraser, a broker at U.S. Bancorp Piper Jaffray in Scottsdale, Ariz. "But I can't tell you what will be doing well tomorrow, which is why you need a little of both growth and value, large and small stock."
Dominance by large-cap growth stocks has raised the question of whether asset allocation is a recipe for all occasions.
When one asset class reigns in such a fashion, diversified portfolios are bound to seem sour. But then, parts of an allocated portfolio always will. Asset allocation is a risk-reduction strategy that provides a rational way for dividing up a portfolio in a manner that reflects individual circumstances.
"Asset allocation keeps you from switching investments like some people jump among lines at the grocery store," Hines says. "Because as soon as you do, the cashier will call for a price check."
Should clients diversify with overseas investments?
Ibbotson Associates doesn't consider international stocks a mandatory portfolio ingredient. Instead, the Chicago-based consulting firm views U.S. stocks, domestic bonds and cash as the essential asset classes, with international equities as an option for some investors. The problem with foreign holdings, says Ibbotson consultant Clay Singleton, is that the performance data on international markets isn't comparable to what's available domestically.
"Foreign stocks may look like they should qualify as separate asset classes, but the data we've gathered isn't as reliable as it is for U.S. stocks and bonds, especially when you slice the foreign pie among the large, small, growth and value categories," Singleton says. "If you don't have enough data, you run the risk of drawing false conclusions."
Some clients resist venturing into certain areas. "The toughest sell is the emerging markets," says Jim Pupillo, a wirehouse broker in Scottsdale, Ariz. "Many people have the impression that international stocks are riskier. And some people who served in foreign wars have a negative bias against certain countries."
Tom Ruder, an Edwards Jones broker in Evansville, Ind., doesn't encourage clients to venture abroad. He believes stateside investors can participate in the growth of foreign economies by investing in U.S. multinationals like Coca-Cola and General Electric. With these types of stocks, there's little need to decipher foreign accounting statements or worry about currency fluctuations.
Still, most analysts acknowledge that there are long-term diversification gains to be had with foreign securities in the mix. American companies don't dominate every industry. Nor is the U.S. economy likely to exhibit vigorous growth forever.
"I ask clients to look at the different cars on the road or various products in their homes and offices," says George Fraser, a broker at U.S. Bancorp Piper Jaffray in Scottsdale, Ariz. "They quickly get the drift that it's an international marketplace, and that we don't make everything."