Standard and Poor's Guide to the Perfect Portfolio : Five Steps to Allocate Your Assets and Ensure a Lifetime of Wealth

Michael Kaye, a portfolio officer at Standard and Poor's, cites studies that documented the importance of asset allocation over individual stock selection. He defined asset allocation as "the process of determining the optimal way to divide a broad range of categories of assets (stocks, bonds, cash, and others) in a way that suits your investment time horizon and risk tolerance" (p. 10).  To make this investment decision, he itemized 5 steps: "Step 1: Identify your goals and objectives; Step 2: Choose the specific asset classes in which to invest; Step 3: Determine what percentage of your total assets belongs in each asset class; Step 4: Decide which investment products to use; Step 5: Monitor the performance of your portfolio and adjust your asset mix if warranted" (p. 13).

Of the common types of asset allocation approaches, the buy and hold strategy becomes the default position. Because after the initial purchases the investor takes no action, transaction costs remain low and the asset allocation can veer far from its original makeup. A less familiar approach to the average investor but one that many unconsciously follow, insured asset allocation strategy, entails selling assets that reach the floor in value and buying more assets that appreciate. As Kaye states, "insured asset allocation assumes that your risk tolerance changes with your level of wealth. You have no tolerance for risk below the floor value and an increasing risk appetite above the floor value" (p. 12).

With strategic allocation, the investor decides what percentages he or she designates for each asset class and rebalances periodically to maintain those percentages. Only because of changing goals or events, does the investor change the percentages. This approach accrues greater transaction costs than buy and hold and, like buy and hold, favors a long-term strategy. Tactical allocation, more short-term oriented, opportunistic, and riskier than strategic allocation, results in a change of percentages based on market conditions. Transaction costs grow from the time taken to follow market trends and the increased costs to buy and sell.

Why Tinkering Too Much with Your Portfolio Won't Pay Off

I found the title of this article, circulated on the Australian School of Business newsletter, intriguing. In the age of day traders, I constantly wonder if monthly I should evaluate my portfolio strategy. This article and the research paper that it explains provided an academic view of the issue.

Andrew B. Abel, Janice C. Eberly, and Stavros Panageas, professors at Wharton, Kellogg, and the Booth School of Business at the University of Chicago wrote a highly technical paper entitled, Optimal Inattention to the Stock market with Information Costs and Transaction Costs http://www.nber.org/papers/w15010.pdf?new_window=1 .

The paper makes the assumption that the investor has two accounts, an investment account with equities and a transaction account, a cash account for living expenses.  The paper, additionally, considered two transaction cycles or "observation dates", one that occurred at regular intervals--"time dependent", for example, a monthly withdrawal to cover living expenses; and another that occurred far less frequently--"state dependent", for example, once a decade. To assess transaction costs, the authors included two types, "the value of the investor's time, plus commissions and other charges that apply to any action taken" (p.1).

The authors identified "the period of 'optimal inattention'. "Logic says that the higher the investor's cost of time and money, the longer this period is" (p. 1) They concluded that "it would probably not pay to adjust a portfolio more often than every month or two" given commission and other fees" (p.1).

http://www.nber.org/papers/w15010.pdf?new_window=1