My Asset Allocation Philosophy
If there is one sentence every investor has seen a thousand times, it is this:
Past performance does not guarantee future results.
It is printed on advertisements, investment reports, fund literature, and just about every other piece of financial material you will ever read. We see it so often that most of us probably don’t even notice it anymore.
But I think we should.
Because buried inside that boilerplate disclaimer is one of the most important lessons in investing.
Markets are cyclical. Economies are cyclical. Interest rates are cyclical. Countries are cyclical. Industries are cyclical. Investment styles are cyclical. Investment strategies are cyclical.
We have a natural tendency to look at whatever has worked best recently and assume it will continue to work. If U.S. stocks have outperformed international stocks, we want more U.S. stocks. If passive index funds have beaten most active managers, we begin to wonder why anyone would invest any other way.
After enough years of outperformance, a trend can stop looking like a trend and start looking like a permanent truth.
And that is where I think investors can get into trouble.
That does not mean you should try to predict when a successful trend is going to end. We can’t. It means you should be careful about allowing financial success to become dependent upon that trend continuing indefinitely.
I have my own way of expressing the same idea:
Everything in finance is cyclical.
Every single thing.
Markets are cyclical. Economies are cyclical. Interest rates are cyclical. Countries are cyclical. Industries are cyclical. Investment styles are cyclical. Investment strategies are cyclical.
Everything in finance is cyclical.
And here is the part we really have to internalize:
We don’t know how long the cycles will last.
A cycle might last a day. A week. A month. A year. Ten years. It might conceivably last for generations.
We don’t know.
No one knows.
A cycle does not stop being a cycle simply because it has lasted a very long time.
One of my favorite—and I think most illustrative—examples comes from the history of the stock market itself.
For generations, investors were accustomed to stocks providing higher dividend yields than high-quality bonds. The relationship persisted for so long that many investors came to regard it almost as a law of nature. Stocks were riskier, the thinking went, so naturally they should provide the higher yield.
Then, in the late 1950s, that relationship changed. Stock dividend yields fell below bond yields, overturning a relationship investors had observed for decades—generations, actually. What had looked permanent turned out not to be permanent at all.
That does not mean investors should have predicted the change. And it certainly does not mean we should spend our time trying to predict the next one.
It means something much more important.
Even relationships that persist for generations can change.
That uncertainty isn’t a flaw in investing that we will eventually solve. It is part of investing itself. You have to build portfolios while accepting that we cannot know precisely when one cycle will end and another will begin.
Past performance is evidence.
It is not certainty.
And that idea is at the heart of my approach to asset allocation.
What Diversification Really Means
When most people hear the term asset allocation, they probably think about dividing a portfolio among stocks and bonds.
That’s certainly part of it.
Traditional asset allocation divides a portfolio among broad categories of investments, or asset classes: equities, fixed income, cash, real assets, and, where appropriate, alternative investments.
Ask most financial advisors or asset managers why they combine these different investments and the answer will usually come down to one word:
Risk.
That’s correct.
But we need to be careful about what we mean by risk.
In the investment world, risk is frequently measured by volatility—essentially, how much the price of an investment moves up and down.
Volatility matters. Correlation matters, too. Combining investments that do not always move together can reduce fluctuations in the overall portfolio.
But volatility and risk are not the same thing.
Volatility is one form of risk, and it becomes especially important when time is short.
Imagine you know you will need a portion of your money within the next several years. If that money is entirely invested in stocks and the stock market falls substantially just before you need it, you may have no choice but to sell while prices are down.
Even if the market eventually recovers, that future recovery doesn’t help with money you were forced to spend today.
But over longer periods of time, we need a broader definition of risk.
Long-term risk isn’t simply that the value of an investment temporarily goes down. It is that you permanently lose capital—or that your money fails to grow enough to preserve your purchasing power and accomplish your goals.
That distinction matters enormously.
Losing money is a risk.
But failing to earn enough money is a risk, too.
An investor can avoid nearly all short-term volatility by holding cash, for example, and still experience a very real long-term loss as inflation steadily erodes purchasing power.
So the objective of diversification cannot simply be to minimize volatility.
It must be to manage different kinds of risk.
You can preserve every dollar and still become poorer in terms of what those dollars can buy.
Different Investments, Different Risks
This is where I think traditional discussions of asset allocation sometimes stop too soon.
We often hear that stocks, bonds, cash, and real assets should be combined because their returns are not perfectly correlated.
That is true.
But there is a deeper reason to own different asset classes:
The fundamental nature of the risk is different.
An equity represents ownership in a business.
There is no contractual promise that a stockholder will receive a particular return—or even get the original investment back. A business can succeed spectacularly. It can stagnate. It can fail. An individual company can ultimately become worthless.
The value of that ownership is also uncertain. Two intelligent investors can examine the same business and arrive at very different conclusions about what it is worth.
But that uncertainty comes with opportunity. Ownership allows an investor to participate in the growth of a successful business, potentially for decades. Investors accept that uncertainty because equities offer the possibility of substantial long-term gains.
Fixed income is fundamentally different.
When you buy a bond, you are generally lending money to a company or government under a contract specifying payments the borrower promises to make.
That does not make bonds risk-free. Interest rates change. Bond prices fluctuate. Borrowers can default. Inflation can reduce the purchasing power of the payments you receive.
But the nature of the risk is different from owning a business.
Assuming the borrower remains able to meet its obligations, the contractual payments of a bond make its expected cash flows more predictable. The potential return is generally lower than the potential return from equities, but there is greater predictability about what the investor is supposed to receive.
Cash is different again.
Cash provides extraordinary short-term stability and liquidity. A dollar sitting in cash tomorrow will generally still be a dollar.
But over long periods, cash carries a different and very real risk: inflation can steadily destroy its purchasing power.
You can preserve every dollar and still become poorer in terms of what those dollars can buy.
Real assets have still another set of characteristics.
Real estate, farmland, timber, precious metals, and other tangible assets derive at least part of their value from ownership of something physical. Land is finite. Buildings occupy real locations. Natural resources exist in limited quantities.
That physical nature creates both opportunities and constraints. A piece of land cannot simply multiply, although its economic value can change dramatically depending upon what can be built on it, how it is used, where it is located, and what people are willing to pay for it.
Commodities illustrate the point even further.
Oil, copper, wheat, and other commodities are actual physical goods. Their values are affected by supply, demand, scarcity, production costs, storage, technological change, and economic activity in ways that are fundamentally different from the forces affecting a bond or an ownership interest in a business. Some are durable; others are perishable. Each carries its own particular risks.
None of these investments is simply “safe” or “risky.”
They contain different risks and different sources of potential return because the underlying things themselves are fundamentally different.
That, to me, is the foundation of diversification.
The objective isn’t merely to own a lot of things.
It is to intentionally combine things that are genuinely different.
Diversification Creates Opportunity
There is another consequence of owning investments that behave differently.
Their differences create opportunities.
When a more volatile asset such as stocks falls substantially while another portion of a portfolio remains relatively stable, rebalancing may allow you to move some money from the more stable investment into the asset that has fallen.
When the opposite occurs—when stocks or another higher-risk investment have appreciated substantially and become an increasingly large part of the portfolio—you can do the reverse.
You are not trying to predict exactly when markets will turn.
You are building a portfolio that allows you to respond when they do.
Different assets rise and fall at different times. Their relative values change. Investors periodically become extremely enthusiastic about one thing and pessimistic about another.
Those differences can create opportunities for a disciplined investor to move capital from areas that have appreciated substantially toward areas that have become relatively less expensive.
That doesn’t mean rebalancing will always increase returns. Nor does it guarantee that an investment that has fallen will recover.
Nothing in investing works with that kind of certainty.
But diversification can therefore do something more profound than simply reduce volatility.
Diversification creates choices. Rebalancing gives you a disciplined way to act on those choices.
And that brings me to the second dimension of diversification.
Passive investing is still an investment methodology.
Diversifying How You Invest
The same reasoning that leads you to diversify among stocks, bonds, cash, real assets, and commodities leads me to believe that you should consider diversifying how you invest, too.
Just as different asset classes have fundamentally different sources of risk and return, different investment methodologies have fundamentally different ways of making decisions.
Consider passive investing.
Passive, index-based investing is one of the most efficient innovations ever created for investors. It can be simple, broadly diversified, inexpensive, tax efficient, and extraordinarily disciplined.
A traditional market-capitalization-weighted index owns companies largely in proportion to their value in the market. It does not ask whether a particular company is cheap or expensive before owning it. It provides exposure to the market according to a predetermined set of rules.
That is an enormously useful methodology.
But we shouldn’t confuse its advantages with the absence of an investment methodology.
Passive investing is still an investment methodology.
It is a set of rules for deciding what you own and how much of it you own.
And like every other investment methodology, it creates its own exposures.
It is entirely possible that passive investing could experience an extended period of lackluster—or even little or no real—returns. Other methodologies have experienced extended periods of disappointing performance, and there is no reason to assume any one approach is permanently exempt from cycles.
It is also entirely possible that passive investing could continue to perform extraordinarily well for decades.
You don’t know.
And that is precisely the point.
My philosophy does not depend upon predicting when passive investing will stop working, because I don’t know that it will. It depends upon accepting that you do not want your financial future to require any single methodology to remain dominant forever.
Other methodologies make different choices.
Fundamental active management begins with a different question:
What is this investment actually worth?
A fundamental manager studies individual businesses, their financial condition, competitive position, management, prospects, and valuation, and then uses judgment to determine whether the market price provides an attractive opportunity.
A value-oriented investor deliberately favors investments that appear inexpensive relative to measures of their underlying worth.
A growth investor may be willing to pay more for companies whose businesses and earnings are expected to grow substantially.
Quantitative managers use data and mathematical models to make investment decisions.
Factor-based approaches systematically seek exposure to characteristics such as value, quality, size, or momentum.
Technical and trend-following approaches focus more heavily on price movements and market behavior.
These approaches are not simply different labels for the same thing.
They make different decisions. Different decisions create different risks and different opportunities.
And leadership among investment styles changes.
There have been extended periods when growth stocks have led. There have been periods when value stocks have led. There have been periods when particular active strategies have performed exceptionally well, and long periods during which broad passive indexes have been extremely difficult for active managers to beat.
Why should we assume any one of those relationships is permanent?
If we truly believe that everything in finance is cyclical, we have to apply that principle here, too.
Active Versus Passive Is the Wrong Question
The debate is usually framed this way:
Which is better, active or passive investing?
I think that’s the wrong question.
The argument for passive investing is powerful: most active managers do not consistently outperform their benchmarks, particularly after costs.
That deserves to be taken seriously.
But you don’t need active management, as a category, to beat passive investing, as a category, for carefully selected active strategies to have a place in a diversified portfolio.
Nor do you need passive investing to continue outperforming active management indefinitely.
I want to ask something different:
Do these approaches expose your capital to meaningfully different risks and sources of potential return?
If they do, there may be a rational argument for combining them.
When evaluating active management, you should be less interested in simply finding whichever manager has performed best recently. That would repeat the exact mistake this entire philosophy is designed to avoid.
You should be much more interested in whether a manager has a deeply rooted, repeatable investment process; whether that process makes economic sense; and whether there is evidence that it has worked across different market environments and over long periods of time.
The objective is not to find somebody who happened to win yesterday.
It is to identify genuinely different approaches to investing that have a coherent reason for potentially succeeding over time.
Then you can apply the same discipline that you apply among asset classes.
When one style experiences extraordinary appreciation and becomes an increasingly large part of the portfolio, you can rebalance. When another experiences a long period of relative weakness, you can evaluate whether its underlying investment case remains intact and potentially rebalance toward it.
You don’t have to predict exactly when leadership will change.
You don’t have to know whether value, growth, passive, fundamental, quantitative, technical, or some other approach will dominate the next decade.
You need a portfolio capable of benefiting from more than one possible future.
This, to me, is the broader meaning of diversification.
A portfolio can be diversified across asset classes.
Across countries and regions.
Across company sizes.
Across investment styles such as value and growth.
Across active and passive management.
And across fundamentally different ways of making investment decisions.
Not because more complexity is inherently better.
It isn’t.
Complexity is not diversification.
The point is to combine investments and methodologies that expose you to genuinely different risks and different potential sources of return.
You should not try to predict which asset class, style, country, or investment methodology will win next year. We don’t know.
Rebalancing: Perspective, Not Prediction
Diversification isn’t a one-time decision.
Over time, the portfolio changes.
One asset class performs extraordinarily well. Another lags. One investment style becomes dominant. Another falls out of favor.
Eventually, a portfolio that began diversified can become increasingly dependent upon whatever has performed best recently.
That is why rebalancing matters.
I have my own way of thinking about this, too:
Rebalancing isn’t about prediction. It’s about perspective.
You should not try to predict which asset class, style, country, or investment methodology will win next year.
We don’t know.
But we do know where markets have been.
And we know that periods of extraordinary outperformance can tempt investors into believing recent trends will continue indefinitely.
No tree grows to the sky.
When one part of a portfolio has grown dramatically while another has lagged, do not rebalance because you believe a reversal is imminent.
Rebalance because concentration itself creates risk, and you do not want long-term financial success to depend upon the continuation of a single trend.
Rebalancing requires no prediction about what happens tomorrow.
It requires perspective about what has already happened and discipline about maintaining the diversification deliberately chosen in the first place.
A Unified Idea of Diversification
This brings everything back to one principle.
The purpose of asset allocation is not to find the single best investment. It is to combine different kinds of risk intelligently, because no one knows which risks will be rewarded next—or for how long.
Diversification isn’t simply about owning lots of investments.
It isn’t simply about reducing volatility.
And it isn’t simply about protecting ourselves from losses.
It is about constructing a portfolio in which different investments and different investment methodologies can respond differently to an uncertain world.
Those differences can provide stability.
They can help protect purchasing power.
They can provide opportunities for growth.
And because they behave differently at different times, they can create opportunities to rebalance.
There will always be something in a truly diversified portfolio that disappoints us.
That’s not necessarily evidence that diversification isn’t working.
It may be evidence that it is.
No asset allocation can eliminate risk. No diversification strategy can guarantee gains. And no investment philosophy can ensure a particular return.
That isn’t the objective.
The objective is simpler:
Build portfolios that do not require us to know the future.
An investor’s financial success shouldn’t depend upon correctly predicting which asset class will perform best next year, which country will lead markets over the next decade, whether value or growth will dominate, whether active or passive management will lead, or precisely when today’s winning strategy will stop winning.
Because you can’t know those things with certainty.
Instead, you can build portfolios capable of benefiting from more than one possible future.
Diversify across different risks.
Diversify across different sources of potential return.
Diversify across different ways of investing.
And rebalance with discipline when those differences create opportunities.
Which brings me back to where we started.
Every investor has seen the disclaimer:
Past performance does not guarantee future results.
I believe that is much more than legal fine print. It is one of the deepest truths in investing.
My way of expressing the same idea is simple:
Everything in finance is cyclical. We just don’t know how long the cycles will last.
That uncertainty does not lead me to make more predictions.
It leads me to think about diversifying more thoughtfully.
It leads me to think about rebalancing—not because I know what will happen next, but because I have the perspective to recognize that what has worked in the past does not have to work in the future.
Rebalancing isn’t about prediction. It’s about perspective.
We cannot know the future.
But you can build portfolios that do not depend on knowing it.
That, ultimately, is my philosophy of asset allocation.