Understanding asset allocation: Part 1
In 1986, a study authored by professors Gary Brinson, Randolph Hood and Gilbert Beebower appeared in the Financial Analyst’s Journal, July-August edition, that attributed 94 percent of the overall investment return in a given portfolio of financial assets to asset allocation.
That finding has become one of the guiding principles of investing for successfully building a retirement nest egg.
What this means is that before investors start selecting particular securities and/or mutual funds (the principle of diversification), they need to make a key decision regarding their overall risk-return, or asset allocation, position.
First, let’s define this fancy sounding term. Asset allocation is a decision that involves making a determination as to what percentage of an investor’s portfolio should be invested in stocks, bonds and cash equivalents (often referred to just as cash), which are the three major financial asset classes.
These assets perform differently and carry differing risks. Historically, stocks have gained an average of about 10 percent a year; bond returns have been around 6 percent; and cash investments have been in the 3 percent to 4 percent range.
The difference in returns is a function of the level of risk involved in each of the three asset classes. In the world of investing, risk produces return, but it also means that the possibility of the loss of principal is ever present.
Often times, the less-experienced investor tends to focus on high-return opportunities, forgetting that return and risk are commensurate.
For an individual investor, deciding on appropriate asset allocation is a judgment call. One size does not fit all.
Even in the case of investment professionals, it is not uncommon for them, looking at the same investor profile, to come up with significantly different apportionments (percentages) for stocks, bonds and cash in a portfolio recommendation.
Nevertheless, when it comes to deciding on your asset allocation, there are some practical guidelines to follow:
For decades, pension funds have generally followed the “60-40″ rule ” 60 percent in stocks, 40 percent in bonds ” for managing defined corporate benefit plans. This is not a bad example to follow.
For most of the investing public, an allocation at or close to these percentages makes sense. Remember, we’re talking here about funding your retirement, which probably means erring somewhat on the conservative side.
Another key consideration over the five years is the low investment return environment predicted by a large majority of market observers. I think this will narrow the difference between stock and bond returns, and make the latter more competitive as an asset class selection for long-term investors.
As I noted in my July 28 article on cash assets, except for special circumstances, this category of asset is not appropriate for building a retirement fund. The return on cash is generally at or below the historical rate of inflation and simply does not carry enough investment punch to get the job done.
The more cash assets you have in your portfolio, the harder the pull for your stocks and bonds.
Avoid aged-based, aggressive-posture recommendations when considering your asset allocation position. Often times investment guidance encourages “young” investors to allocate 80 percent, or higher, to stocks, on the premise that they have a long investment horizon and can take the risk.
While this premise has some validity, here’s some “brutal math” from the Wall Street Journal’s Jonathan Clements (July 10): A 25 percent loss, not atypical in aggressive growth stocks, in a $100,000 portfolio requires the remaining $75,000 balance to churn out a 33 percent gain just to recover the full $25,000 loss.
Clements points out that “the steeper the loss, the more daunting the climb back.” Obviously, so-called aggressive portfolios are more susceptible to this phenomenon than the more balanced variety.
More on understanding asset allocation next week.
The Investing Wisely column is written by Richard Loth, managing principal of Mentor Investing and an independent registered investment adviser. Loth can be reached at 827-5591 or email@example.com.
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