MBA Series – What Makes Asset Allocation So Important? “Don’t put all of your eggs in one basket.” The beginning of the year is typically portfolio rebalancing time for investors. I write a lot about investing as it is an achievable path to long-term wealth. If you don’t know what asset allocation is or much about investing at all, then this article is for you. Modern Portfolio Theory is the science that drives most of the writing about investing today. After teaching a university Investments class, and reviewing the concepts of Modern Portfolio Theory, I’m reminded the key reasons that asset allocation is important. What is Asset Allocation? When creating an investment portfolio, asset allocation means selecting specific asset classes and choosing the percentage amount invested in each asset class.  Sample asset classes are: U.S. Stocks U.S. Corporate Bonds International Stocks International Bonds Real Estate or REITs Government Bonds Small Cap Stocks Large Cap Stocks Diversification – Tried and True Investing Diversification in investing means don’t put all of your money in one investment or one type of investment. Why diversify? There aren’t many people that can stomach three years of declining stock prices. In 2000, the market dropped a total of a 42.85% during 2000 through 2002. S&P 500 With a concentrated portfolio, when that investment goes down, there goes the value of your invested assets-down. And vice versa. Buy different types of investments, so that when one goes down in price, the others may go up, or at least remain stable. Diversification smooths out the ups and downs of your investments. For example, it is rare for bonds and stocks to go down drastically at the same time. During certain years, bonds will outperform stocks, and in others, stocks outperform bonds. S&P 500 Dividends ReinvestedUS Small Cap3-month T. BillUS T. Bond (10-year)Baa Corporate BondReal EstateGold201721.61%15.13%0.95%2.80%9.15%6.21%12.66%2018-4.23%-16.21%1.97%-0.02%-3.18%4.52%-0.93%201931.21%11.92%2.11%9.64%15.25%3.69%19.08%202018.02%34.16%0.36%11.33%10.60%10.43%24.17%202128.47%22.41%0.04%-4.42%1.02%18.86%-3.75%2022-18.04%-22.90%2.09%-17.83%-15.23%5.65%0.55%202326.06%5.19%5.28%3.88%8.74%5.68%13.26%202424.88%8.70%5.18%-1.64%1.74%3.96%25.96%202517.78%16.53%4.21%7.80%6.96%1.58%66.22% Source: https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html Take a look at a 2022 anomaly: high inflation and subsequent interest rate spikes, caused a S&P 500 tumble of -18.04% and the 10-year US Treasury bond to plunge -17.83% simultaneously. However, look at how beautifully the balance restored itself just a year later: in 2023, the S&P 500 soared 26.06% while bonds stabilized with a return of 3.88%. Despite the stock and bond market losses in 2022, your investment losses would have been tempered, had you also owned real estate and gold. Real estate delivered a 5.65% gain and Gold remained flat with a 0.55% uptick. Over long periods, combining these asset classes drastically curtails your portfolio’s overall volatility. Bonus: What Should My Asset Allocation Be? Over long periods of time stocks have outperformed bonds, but a combination of diverse asset classes reduces your portfolio volatility (as measured by standard deviation). Notice that in 2021, the S&P 500, a proxy for the stock market averaged 28.40% return, while the 10 year Treasury bond lost 4.42%. Next, travel back in time to 2008 when the S&P 500 sunk a disastrous -36.55% and the 10