Celebrate Diversity

It’s difficult if not impossible these days to find an asset manager or financial planner willing to wax poetic about a soon-to-be realized “home run” in the financial markets—whether that pertains to stocks, bonds, gold, or pork bellies.

The “trees grow to the sky” crowd—remember the book Dow 36,000?—has faded from the scene about as completely as the Hummer H1 (or H2 or H3, for that matter). The message these days? Many if not most assets are poised for a long period of low returns. More than ever, investors are being implored to diversify. Spread your risk, because virtually all types of investments, trading at current valuations in such a jittery world economy, are one external shock away from falling off the edge of the table.

Windsor Financial Group in Minneapolis has long pounded the table for asset allocation. Windsor manages $1.6 billion in assets, about $500 million of which is managed in balanced portfolios for wealthy individuals and small to midsize endowments and nonprofits. David Koch, a partner who heads up the firm’s equities group, also serves as Windsor’s chief compliance officer.

{Q} We hear a lot about asset allocation. What are you telling your clients about it?

{A} We tell them that asset allocation is paramount for two reasons. The most important is risk management—clearly, different asset classes perform differently in different market environments. When investors spread their monies among various asset classes, the overall risk of the portfolio is lowered because of the correlation effects of those asset classes, so there’s less volatility in the portfolio—and, on a risk-adjusted basis, higher returns.

{Q} Asset allocation has involved a mix of domestic stocks, bonds, and cash. Is that still the case?

{A} No. It’s clearly more than that. I think some managers still use stocks, bonds, and cash—pick numbers out of the air, the old 60/40 rule. We think it’s more than that—it’s domestic stocks, international stocks, bonds, real estate and alternative investments, the latter of which incorporates nontraditional asset classes, such as hedge funds, private equity, and commodities, including gold. Again, anything that has a low or negative correlation to your traditional stock and bond asset classes are included in the alternative class.

Broadly speaking, [investors] should own domestic stocks and bonds, international stocks and bonds, real estate, and alternatives.

{Q} Do all your clients have the same allocation?

{A} No. That will vary according to an investor’s tolerance for risk, time horizon, and particular circumstances. The allocation to the various asset classes may well differ for different investors. The ultimate goal is to create a customized portfolio with a combination of asset classes that land on the efficient frontier, the cornerstone of modern portfolio theory. In other words, we attempt to create a diversified portfolio that gives the highest return for the least amount of risk and ultimately meets the client’s return objective.

So generally, most portfolios are going to have some allocation to most of the available asset classes—and again, that will vary somewhat based on an investor’s tolerance for risk and return objective. Moreover, we will adjust allocations based on valuations.

{Q} Have you tended to underweight certain asset classes?

{A} Yes and no. Real estate, for example, we have included in portfolios; but because of the valuation concerns, the weights are somewhat less than some traditional models might dictate. Traditional asset allocation models basically assume that the future is going to look like the past, so what happens is some managers or investors overweight many sectors because of past performance and, in effect, create a poorly diversified portfolio. We don’t think the future is going to look like the past. The world has changed, as have the capital markets. Consequently, we think return assumptions need to be lowered for most asset classes.