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Rules of the Game: Safety and Growth

Institutional-style diversification aims to mitigate risk.
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Not long ago, a U.S. investor's asset allocation was a pretty typical mix: Domestic equity and fixed income, international developed equity, and maybe a smattering of emerging-market stocks or some real estate investment trusts (REITs).

That's not a badly diversified portfolio, and certainly spreads the risk around so you avoid being over weighted in any one area. But it's possible to diversify even further, while capitalizing on better-performing asset classes.

For most of us, the memories of 2008 and 2009 are fresh in our minds. Plenty of people remain so risk-averse that they keep large percentages of their investable assets under the mattress (or in money-market accounts, which is really the same thing) to protect against some loss that hasn't yet happened. The sad part is, cash doesn't keep up with inflation, so all that so-called "protection" has been for naught, as equity markets rallied in the past five years.

We want safety and growth!  Well, maybe that's just my Dad who keeps insisting he can get both -- but I suspect he's not alone in that. Realistically, we know we need to take risk to get the reward, but people tend to err toward one extreme or the other when they self-allocate.

But institutional investors have moved more toward the "core and satellite" approach that I have been writing about recently. Institutional-style diversification aims to do the so-called impossible: manage growth while mitigating downside risk.

But how do you choose which active investments you want to add? It's not necessarily the case that fundamental or technical screens will reveal the right answers at the right times. Many active managers, those who pick stocks or funds, will tell you they have some kind of edge or system to consistently beat, well, something.

When you add an active component to your portfolio, ask yourself a few questions.

  • What market inefficiency are you trying to exploit? (Hint: Most of the time, this means you're trying to identify a "misplacing.")
  • What research or evidence compels you to believe that such an inefficiency actually exists? (This is a tricky one, and it means digging deeper than an opinion on the financial news.)
  • What special insight or technique do you have to effectively exploit the inefficiency?

By the way, if you are working with an advisor who uses active management, I suggest asking the same questions. Not to play some game of "stump the panel," but to fully educate yourself about how your money is invested. Again, not to be a jerk, but so you understand why you are getting the returns you are getting, in a specific time period.

For example, in 2013, investors who didn't understand a diversification philosophy were puzzled as to why their returns didn't match the S&P 500. They probably weren't so eager to match the S&P in 2008.

There are some more questions to ask, when you are looking to get an edge in your investment-allocation strategy. I'll come back to some of those later in the week.