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How Important is Asset Allocation?


Caution is warranted in assessing these claims.

There have been many discussions of the importance -- or unimportance -- of asset allocation as a method for reducing risk when investing. I'm going to offer my contribution to this ongoing conversation.

I consider this to be a topic of vital importance to the economic survival of investors all over the world (how's that for drama?) that I plan to devote several posts to this discussion.

For years, many investment professionals claimed that most of the profits derived from an investment portfolio have been the result of proper asset allocation. The results of 2008, when essentially all assets got clobbered, has resulted in a rethinking of this time-honored method for investors to reduce risk. As a professional options trader for more than 30 years, I've been aware that options provide a much better method for risk reduction, but that getting the individual investor interested in learning how to use options has been a difficult battle. Very much tilting at windmills.

Tools for the Money, a site that offers financial planning software, says something that contains an aside statement -- but that aside is, in my opinion, the key to risk management: "Asset allocation is the only non-derivative technique you can use to reduce risk (lower overall portfolio volatility), increase income, and get better returns, all at the same time. It's the only one of the 3 ways of managing money that reduces risk." (The other 2 methods they mention are market timing and stock selection.)

They go on to say many wonderful things about the merits of asset allocation. But to me, the most important part of their statement is the acknowledgment that asset allocation is the best method for reducing risk -- when one isn't using derivatives.

Well, no kidding! That's the point I've been trying to get across to the investing public as well as to financial journalists, bloggers, and professional advisors. Derivatives. Options. That's the twenty-first-century investment tool required for successful risk management.

Sure, it takes a bit of effort to fully understand options and how they work. But isn't it worth your time to learn how to protect your assets and guarantee that you'll never again suffer losses such as those felt by far too many investors when the technology bubble burst in 2000 or the market collapsed in 2008?

I've discussed how to adopt a basic collar strategy, and that's the method I recommend for investors who are joining the discussion at this stage -- i.e., looking for something better than "asset allocation" or "diversification" to protect the value of a portfolio.
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No positions in stocks mentioned.

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