Behavioral Finance and Investor Types: Managing Behavior to Make Better Investment Decisions

Chapter 13

What Is Asset Allocation?

Put all your eggs in one basket—and watch that basket!

—Mark Twain

Nearly everyone involved in advising private clients on their investments knows or has heard that asset allocation is the most important decision an investor can make vis-à-vis long-term investment performance. Importantly, a more-than-trivial number of investors and advisors either choose to ignore this sage advice or think they can pick a roster of active managers that can outperform a well diversified investment portfolio. So, if it is necessary to say it again, asset allocation is the most important decision an investor makes when designing his or her investment portfolio—period. But what many people often overlook is that asset allocation is both a quantitative (science) and qualitative (art) exercise. Because asset allocation is quantitative by nature—we talk about expected return, efficient frontier, percentages, and so on as inputs into the asset allocation selection process—there is a tendency for many to take a mostly, if not purely, quantitative approach. However, there is just as much art as there is science in selecting an appropriate asset allocation for your client. And when one factors in psychological biases, risk tolerance, multi-generational issues, and taxes, the asset allocation decision becomes even more of a subjective decision.

This chapter is intended to provide an overview of the importance of asset allocation. The chapter will be organized as follows: ...