The Sector Strategist: Using New Asset Allocation Techniques to Reduce Risk and Improve Investment Returns

CHAPTER 8

Bonds, REITs, and Commodities

Good intelligence is nine-tenths of any battle.

Napoleon

In addition to common stocks, other asset classes, such as bonds, real estate, and commodities (including timberland and precious metals) can be an essential part of a diversified investment portfolio. I recommend these investments as a complement to stocks within the five major sectors: health care, consumer staples, energy, technology, and financials. Adding these investments to a portfolio is utilizing a process known as asset allocation. The asset allocation theory (divvying up capital between various stocks, bonds, and cash) dates back to 1952 when Harry Markowitz showed that an asset's risk was related to both its volatility and its correlation with other assets in the portfolio. The Markowitz model was the initial spark for academics to examine the relationship between different assets. Asset allocation gained national prominence after a landmark study conducted in 1986 by Gary P. Brinson, L. Randolph Hood, and Gilbert L. Beebower.¹ These gentlemen found that 93.6% of the total variation in portfolio results was attributable to asset allocation. A follow-up study by Brinson, Beebower, and Brian D. Singer² confirmed this result, indicating that asset allocation explained 91.5% of variation in returns. These results underscored the importance of a well-thought-out asset allocation strategy.

Through the 1990s, asset allocation garnered more and more attention. The theory also ...