Implementing our portfolio strategy originates with determining appropriate allocation between equity and fixed income for each investor. Getting this decision right is absolutely critical to long-term investing success.

Within the context of the entire portfolio, the primary function of fixed income is narrowing the wide expected range of returns of an all-equity portfolio to a level tolerable for the investor. This increases their likelihood of maintaining a consistent long-term allocation, improving their probability of success. Reducing volatility of the overall portfolio is best achieved when the bond component is relatively price-stable. Our beginning point for the bond allocation, therefore, is in shorter maturities and high credit quality, where the greatest price stability is found. An important secondary function of fixed income is to serve as a liquidity source for investors requiring portfolio distributions during times when equity markets are behaving badly.

In thinking about equity allocation, our beginning point is a “market-neutral” portfolio: one where allocation to domestic, foreign developed-market and foreign emerging-market companies is similar to their respective share of global market capitalization.

From this point of origin, we recognize three factors that tend to influence allocation away from market-neutral weights:

  • Most investors have some degree of “home bias;” they prefer holding securities from their home country versus those from foreign markets.
  • Evidence suggests that, for U.S. investors, the maximum diversification benefit afforded by foreign positions may actually be achieved by holding them in less than their market-neutral weight.
  • For U.S. investors, the costs of investing internationally remain higher than those of investing domestically.

Once allocation to domestic, foreign developed and foreign emerging has been determined, we look to increase exposure to compensated risk factors described in the academic work of Professors Eugene Fama, Sr. and Kenneth French. Notably, Professor Fama was awarded the Nobel Prize in Economic Sciences in 2013. Fama and French’s work regarding risk factors was first published in the early ‘90s, and initially known as the “Three-Factor Model.” Accepting exposure to small companies and value (high book-to-market) companies, in weights greater than they exist in the market as a whole, “tilts” the equity portfolio toward market segments with demonstrated higher long-term returns versus a market-neutral portfolio. More recently, academic work demonstrating a return premium for, as well as a methodology to identify, companies with higher future profitability has made Fama and French’s initial work more robust in its explanatory power.

In making all these allocation determinations, our financial advisors are mindful of creating portfolios for our clients that are reasonable versus optimal. “Optimal” implies the future can be accurately predicted by analyzing the past. We find little evidence to suggest this can be done reliably. Broadly understanding risk and return relationships between various asset classes over time, however, helps inform decisions about what constitutes a reasonable portfolio structure.