The foundation of a solid process is a set of beliefs that drive it. Determining beliefs helps to maintain focus, build consensus, and promote success. More importantly, these beliefs provide guideposts to assure a constant application of a disciplined investment philosophy.
The essential building blocks of any asset allocation process and its subsequent recommendations are to first understand what one stands for. These beliefs, outlined here, help drive the LPL Financial Research asset allocation framework that positions you with the best opportunities for investment success.
- Price matters. There is really only one rule that works in investing: buying low and selling high garners positive returns. Knowing the price of an asset class relative to its historical trends helps to determine the future price of that asset class. In the end, one can only achieve an average rate of return if one starts at an average price. By focusing on asset classes that are poised to benefit from reversion to the mean, LPL Financial Research positions clients for future success. Thus, we believe that where one starts is a key determinant of where one ends up.
- There is no value premium. We do not agree with an industry misconception that there exists a value premium, which implies that the value style is a fundamentally better investment than growth. In the end, the value style is not always undervalued relative to growth. Thus, our price matters belief drives our process to focus on the style, value or growth, which has the best opportunity for future success. Additionally, history shows that the key differential in total return between value and growth has been the yield spread (difference in dividends); however, this differential has been on the decline. We believe that allocations between value and growth should not be predicated on an imbedded value premium, but rather which offers the better chance of future success.
- There is no small cap premium. Similar to the value premium argument, the industry has a misguided belief that small cap stocks offer a return premium over large cap stocks. History shows that small and large company stocks are both attractive, but neither offers a consistent return premium over the other. Thus, we believe that allocations between different market caps should not be based on an implied premium, but rather which offers the better future investment opportunity.
- There is neither an international premium nor international discount. With continued globalization, some of the inherent risk exposure and return benefits historically present in international investing are becoming more negligible. Therefore, international investment should be viewed as another option in the asset allocation puzzle—on par with other domestic equity investments. We believe that there is not an inherent premium or discount in international investing.
- Implementation matters. There are three levels of asset allocation: strategic asset allocation, tactical asset allocation, and implementation. The best strategic asset allocation or tactical asset allocation is irrelevant if one cannot invest to take advantage of these opportunities. We believe in creating an asset allocation recommendation, we must ensure the resulting strategy can be optimally implemented.
- More diversification is better than less. Though we always position the portfolios to the most attractive asset classes, there is always the risk of being wrong. The best hedge for being wrong is to diversify. We believe allocating assets to more investments than less—if done with consideration to how those investments combine—is prudent.
- Each asset class warrants its own spotlight. Each asset class being considered for usage in our asset allocation models deserves it own set of expected return and risk assumptions. Simply making assumptions for the core asset class and then dividing the consequent allocation to get style or cap allocations is not effective. We believe all asset classes are not equal—nor should their expected risk and return assumption be.
- Cash needs to be managed too. Cash is an important component of a portfolio. It can offer downside protection qualities and reduces the need for multiple transactions when clients need distributions. However, our goal is to garner long-term returns above those attained by cash. We believe, therefore, that the right balance of return potential and distribution convenience needs to be weighed at all times when establishing the strategic and tactical weights to cash.
Not only must our asset allocation be something our advisors can implement, but also it must also be something they want to implement for you. We believe we must take your needs and wants into consideration when creating our asset allocation models.
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