• Investors should target a level of acceptable volatility instead of seeking to maximize investment return.

• Attention to asset class correlation is critical for effective portfolio diversification.

• Key areas of opportunity include U.S. corporations, emerging markets and commodities.

In my 2013 outlook, I provided some color on why I favor certain asset classes. Of course, relating asset class return forecasts to calendar intervals is one of the more foolish traditions of the investment industry. I continue to advocate as strongly as possible that investors construct their portfolios based on individual risk tolerance rather than seeking to maximize investment return. Expected return forecasts are, at best, informed “guesstimates,” but it’s how investors tolerate (or fail to tolerate) volatility that makes risk real.

The table below shows my view of several asset classes across three criteria.

1. The first is my expectation for the most likely range of return potential. I also indicate the possibilities for variance in the forecast returns and for nominal losses.
2. The second criterion is volatility. Investors must consider the level of variation they can tolerate in conjunction with the “point to point” expected return.
3. Lastly, I assess how the asset class correlates with low beta equities; this is intended to help investors determine how a particular asset class can diversify their portfolio. In general, high diversification impact is good and low is bad. For example, two asset classes with high volatility but low correlation may be acceptable. However, two asset classes with high volatility and high correlation would not be a wise pairing for most investors.

Highlights

• Since 2009 I have advocated investing in a U.S. corporate income portfolio, i.e., a portfolio of U.S. equities,  high-yield bonds and convertible bonds/preferred stocks
• To offset the relatively low beta U.S. exposure, I recommend exposure to the higher beta emerging markets and Asian markets. I like both debt and equity in these areas.
• I continue to advocate for exposure to commodities. Investors must remember that commodities are highly volatile, but most scenarios relating to a recovery in global economic growth suggest an increase in demand.

Read the full analysis in the January 23 issue of Perspectives.

See more Market Insights from Columbia Management.