ITA Wealth Management

Before one can build a rational and well-diversified portfolio, it is essential to understand some of the basic principles that under-gird asset allocation.  Below are a few of those principles.  Many of these have been articulated over the past year, but it is always good to review fundamental material.

1. Return and risk are intimately inter-connected.  When constructing a portfolio to increase return, one takes on more risk.
2. Risk can be reduced by investing over a broad array of asset classes, but it is not a given that adding an asset class will automatically lower portfolio risk.  For example, an international ETFs of developed countries has a higher correlation to the S&P 500 than one might imagine.  Recently I was working on a portfolio where the international ETF had a correlation of 87% with the S&P 500 and 89% to the total portfolio.  Adding such an ETF to the portfolio does little, if anything, to mitigate risk to the investor.  Such additions give only the illusion of diversification.  Due to changing correlations, one needs to monitor the portfolio on a regular basis.  Most investors can get by doing this every six months to a year.  I do it more frequently.
3. The return of the portfolio is highly dependent on the choice of asset classes.  Several research papers tell us that 100% of the return is tied to how the assets are allocated.
4. Analysis of the different asset classes in combination with each other is necessary to increase the Return/Risk ratio.
5. Contrary to common sense, adding a few highly selected individual stocks frequently increases return, lowers risk, and increases diversification.  It is not difficult to find strong stocks with correlations below 60% when measured with respect to the S&P 500.

The very basics asset classes to cover in a portfolio should included the following:  U.S. equities, developed international equities, bonds, REITs, and emerging markets.  Once the five basic asset classes are covered, one might expand into commodities, international REITs, and international bonds.

When it comes to U.S. equities, I tend to include no more than seven of the nine Morningstar asset classes.  Investors with a small portfolio can get by with one index fund, the VTSMX or the VTI ETF.  There are many directions one might go with emerging markets.  I tend to stick with EEM or VWO.  There are individual countries investors with larger portfolios may want to include in the emerging market asset mix.  There are also many opportunities in the bond arena.  The available portfolios illustrate what bond ETFs I use in the portfolios where this asset class is appropriate.

Be mindful of the importance of asset allocation and use it to your advantage.

Lowell Herr

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