Hennion & Walsh Trending

Some have suggested that traditional forms of asset allocation strategies failed in 2008 and perhaps will not play as significant of a role in portfolio management techniques going forward. I would suggest that the benefits of asset allocation were exemplified in 2008 and asset allocation itself will likely play an even more significant role in portfolio management in the months and years ahead.

What changed during the period of historic volatility that the markets witnessed in 2008 was not the effectiveness of asset allocation but rather the correlation of the underlying asset classes that make up an asset allocation strategy. Correlation in the world of asset allocation can be defined as the relationship between asset classes where a positive correlation would indicate that the asset classes move in similar direction to one another in response to market movements. A negative correlation, on the other hand, would indicate that the asset classes do not move in the same direction to one another in response to market movements. Having negatively correlated asset classes in an investment portfolio can help to provide for the diversification that many investors are looking for.

Virtually every asset class was impacted by the fallout from the global credit crisis of 2008 where general investor confidence was lost and redemptions from a wide variety of investment vehicles occurred in high volumes. As a result, correlations between asset classes increased (i.e. most were following the downward paths of the market albeit to different degrees) ,which may have given some the impression that asset allocation in some way did not protect capital on the downside as much as they would have expected from a historical perspective.

A careful look at the data would suggest otherwise. While it is fair to say that most asset classes have experienced losses so far in 2008, it is important to realize that actual performance varies between asset classes, in some cases considerably. Consider the following 2008 year-to-date (“YTD”) index returns from Wachovia Securities as of December 11, 2008:

As you can see from the chart above, equity asset classes have exhibited positive correlation from a performance perspective thus far in 2008, albeit to different degrees, while bond oriented asset classes appear to have held up much better during this rocky period. Hence, depending upon the asset allocation strategy that was in place, a portfolio with allocations to different asset classes was likely to outperform portfolios of certain single asset classes. For example, a hypothetical portfolio invested entirely in the S&P 500 Index would have experienced a 37.66% YTD loss as of December 11, 2008. On the other hand, a portfolio that was 50% invested in the S&P 500 and 50% invested in the LB Aggregate Index would have experienced an 18.10% YTD loss as of December 11, 2008.*

More than anything, I believe that 2008 has taught us that asset allocation remains of the upmost importance and should always be constructed in accordance with one’s investment objectives, investment timeframe and tolerance for risk. We now need to challenge traditional notions of asset class correlations and rebalance our portfolios accordingly. Additionally, I would suggest that a wider breadth of asset classes need to be considered in asset allocation strategies (Ex. Commodities, Diversified Emerging Markets, etc… ) in an effort to discover new areas of negative correlation.

*Past performance is not an indication of future results. An investor can not invest directly in an index. These figures are for illustrative purposes only and do not depict an actual investment. Asset allocation does not ensure a profit or protection against a loss. Please note that asset allocation may not be appropriate for all investors.