According to Investopedia (Asset Allocation Definition, 2013), asset allocation is an investment strategy that aims to balance risk and reward by distributing a portfolio’s assets according to an individual’s goals, risk tolerance and investment horizon. There are three main asset classes: equities, fixed-income, cash and cash equivalents; but they all have different levels of risk and return. A prudent investor should be careful in allocating each asset class to his portfolio. Proper asset allocation is a highly debatable subject and is not designed equally for everybody, but is rather based on the desires and needs of the individual investor. This paper discusses the importance of asset allocation, the differences and the proper diversification within the portfolio.
Asset allocation decisions made by an investor are considered more important than other decisions such as market timing or security selection. In the research provided by Hensel (1991), performance attribution is one of the main components when choosing the right assets in a portfolio. The impact of any investment decision can be measured by comparing its outcome with the outcome of some alternative decision. Furthermore, according to Hensel (1991), every investor has to incorporate the minimum-risk portfolio, which is a combination of securities or asset classes that reduces the uncertainty of future portfolio returns to a minimum.
In the paper published by Xiong (2010), it is presented that a portfolio’s total return can be disintegrated into three components: the market return, the asset allocation policy return in excess of the market return, and the return from active portfolio management. The asset allocation policy return refers to the fixed asset allocation (beta) return of the funds. In his paper, Xiong (2010) mentioned that a study by Brinson, Hood, and Beebower (BHB 1986), found that asset allocation policy has an explanatory power of more than 90 percent for the total return variations. It is also pointed that by using time-series and cross-sectional data they can answer the question: Is the difference in returns among funds the result of asset allocation policy or active portfolio management? After they removed the dominant market return component from total return, they could prove that within a peer group, asset allocation policy return in excess of market return and active portfolio management are equally important. So, an investor has more options like to create a portfolio and diversify with different asset classes or pay a small fee and have a professional manager take care of that. It depends on the behavior, the knowledge and risk tolerance of each investor.
In Lynott (2005) paper on proper asset allocation, he argues that allocating the assets skillfully among the various classes of investments is more important than the selection of individual stocks or mutual funds. In this regard, every investor should take a systematic look at where is his money...