7 Key Takeaways from The Intelligent Asset Allocator

by Matt Spillar · January 17, 2018

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asset allocation

If you’ve been following along, earlier this year my dad issued a challenge for me to start reading investment books. You can read my recap of book #1 here, book #2 here, and book #3 here. Today it’s time to recap the fourth and final book in the challenge: The Intelligent Asset Allocator by William Bernstein.

Unlike the other three books, this book was relatively short, at only 225 pages. It was a fast read, with very little fluff included. It also included short descriptions breaking down the math behind the concepts being presented. There is a big focus on statistics woven throughout the text.

The overall premise is clear from the title, Bernstein is walking the reader through the basics regarding the asset allocation in your portfolio. This is geared towards people who will be self-managing their portfolios.

Here are my key takeaways:

Modern Portfolio Theory

Bernstein is a big believer in the modern portfolio theory, which is the theory of how portfolios can be constructed in a way to maximize returns for a given level of risk. The more risk an investor is willing to take on, the higher the potential returns.

He also talks about how an investment’s risk needs to be evaluated on how it impacts your portfolio, rather than on its own.

“You have just been introduced to one of the fundamental laws of investing: in the long run you are compensated for bearing risk.”

Efficient Frontier

The concept of the efficient frontier is that there are a number of efficient portfolios that produce the highest return for the lowest level of risk. The problem is that there’s no way to no what this portfolio allocation will look like ahead of time. These efficient frontiers also change over time, so past performance won’t indicate the efficient frontier of the future.

However, by looking at many different time periods investors are able to determine types of portfolios that get close to this efficient frontier. This is why we set up an asset allocation and then stick to the plan.

Determining Your Asset Allocation

There is a three step process for creating the proper asset allocation for your portfolio:

Determine your stock-to-bond ratio
Determine your portfolio complexity (how many asset classes you want to have. The more asset classes, the more complex your portfolio.)
Determine your acceptable tracking error (this means how far away from the market average are you comfortable being.)

Rebalancing

Once you’ve determined the right asset allocation for your goals and risk tolerance, set it and leave it be. Every so often, about once per year, rebalance your portfolio to get back to your original asset allocation. This is the most effective way to maximize your returns and reduce your risks, but the psychology behind it is difficult. You’ll be selling “winners” and buying “losers.” While this may feel difficult, this is the way to follow the “sell high, buy low” mantra that you hear so often.

Rebalancing is important to do periodically, but not too frequently. Sticking to your target asset allocation through all the market swings is much more important than trying to pick the perfect allocation.

Dynamic Asset Allocation

Making changes to your asset allocation based on market valuation factors are likely to increase return. Changes based on economic or political conditions are a bad idea and will likely result in lower returns.

Correlation

Bernstein dives into statistics all throughout the book, and one of the key themes is correlation between assets. Essentially, some assets are closely correlated, meaning they’re connected and will move in a similar way up and down. Others, have little correlation and have no bearing on how they each will move. Rebalancing is most effective when your assets aren’t closely correlated and this also reduces your risk. This is an example of why it’s a good idea to hold some bonds in your portfolio, to balance out the volatility of stocks.

This relates to diversification as well. If your asset classes are too closely correlated, you’re not well diversified.

Allocation of Stocks vs Bonds

Perhaps the most practical takeaway from the entire book for me was a simple principle. Bernstein advocates for a 90% stocks/10% bonds portfolio because adding a small amount of bonds to your portfolio will significantly reduce risk while only slightly reducing your long-term returns. This was a huge takeaway for me. Right now we hold 20% bonds in our portfolio, but I’ve wrestled with reducing that amount. Many investors in the personal finance community advocate for a portfolio invested in 100% stocks. This isn’t to say they’re wrong, but for most investors it seems that holding some bonds makes sense.

Bernstein also concludes that value investing (Benjamin Graham’s preferred method of buying companies cheaply) tends to have higher returns than growth investing (Philip A Fisher’s preferred method of buying high quality companies no matter the price and holding them for a very long time).

Final Thoughts

Overall, the key principles in this book are important investing lessons to take to heart. Pick a target asset allocation based on your desired return and risk tolerance. Once you have it set, stick with it through all the ups and downs over the year, rebalancing yearly. Don’t overthink your investment strategy, keep it simple and stay the course.

I’m proud of myself for finishing all four of these books. The content was difficult at times, but I came away with many key principles I can draw from to help reinforce my investing strategy. Thanks for following along with me and I hope you learned something new as well!