A large part of financial planning is finding an asset allocation that is appropriate for a given person in terms of their appetite for and ability to shoulder risk. This can depend on various factors; see investor profile.
Asset allocation in a nutshell
Inherent in asset allocation is the idea that the best-performing asset varies from year to year and is not easily predictable. Therefore having a mixture of asset classes is more likely to meet your goals. A more fundamental justification for asset allocation is the notion that different asset classes offer non-correlated returns, hence diversification reduces the overall risk in terms of the variability of returns for a given level of expected return. In this respect diversification has been described as "the only free lunch you'll find in the investment game." Academic research has painstakingly explained the importance of asset allocation, and the problems of active management. (see academics) This explains the steadily rising popularity of passive investment styles using index funds.
Examples of asset classes
- cash (i.e., money market accounts)
- Bonds: investment grade or junk (high yield); government or corporate; short-term, intermediate, long-term; domestic, foreign, emerging markets
- stocks: value or growth; large-cap versus small-cap; domestic, foreign, emerging markets
- real estate
- foreign currency
- natural resources
- precious metals
- other
To further break down equity investments into additional asset classes consider the following:
- By size:
- Large-Cap
- Mid-Cap
- Small-Cap
- By style:
- Growth
- Blend
- Value
- REITs
- International Investments: foreign or emerging markets
Academic studies
Brinson, Hood, and Beebower published in 1986 a study about asset allocation of 91 large pension funds measured from 1973 to 1985. [1] They replaced the pension funds' stock, bond, and cash selections with corresponding market indexes. The indexed quarterly return were found to higher than pension plan's actual quarterly return. The two quarterly return series' linear correlation was measured at 96.7%, with shared variance of 93.6%. The lessons of the study was that replacing active picks with simple asset classes worked just as good, if not even better than professional pension managers. Also, a small number of asset classes were sufficient for financial planning. One problem with the Brinson study was that the cost factor in the two return series was not clearly discussed.
In year 2000, Ibbotson and Kaplan used 5 asset classes in their study "Does Asset Allocation Policy Explain 40, 90, or 100 Percent of Performance?" [2] The asset classes included were large-cap US stock, small-cap US stock, non-US stock, US bonds, and cash. Ibbotson and Kaplan examined the 10 year return of 94 US balanced mutual funds versus the corresponding indexed returns. This time, after properly adjusting for the cost of running index funds, the actual returns again failed to beat index returns. The linear correlation between monthly index return series and the actual monthly actual return series was measured at 90.2%, with shared variance of 81.4%.
In both studies, it is misleading to make statements such as "asset allocation explains 93.6% of investment return". [3] Even "asset allocation explains 93.6% of quarterly performance variance" leaves much to be desired, because the shared variance could be from pension funds' operating structure. [4] The statistics were most helpful when used to demonstrate the similarity of the index return series and the actual return series.
Performance indicators
McGuigan described an examination of funds that were in the top quartile of performance during 1983 to 1993. [5] During the second measurement period of 1993 to 2003, only 28.57% of the funds remained in the top quartile. 33.33% of the funds dropped to the second quartile. The rest of the funds dropped to the third or fourth quartile.
In fact, low cost was a more reliable indicator of performance. Bogle noted that an examination of 5 year performance data of large-cap blend funds revealed that the lowest cost quartile funds had the best performance, and the highest cost quartile funds had the worst performance. [6]
Return versus risk trade-off
In asset allocation planning, the decision on the amount of stocks versus Bonds in one's portfolio is a very important decision. Simply buying stocks without regard of a possible bear market can result in panic selling later. One's true risk tolerance can be hard to gauge until having experienced a real bear market with money invested in the market. Finding the proper balance is key.
| Cumulative return after inflation from 2000-to-2002 bear market [7] | |
|---|---|
| 80% stock / 20% bond | -31.35% |
| 70% stock / 30% bond | -25.81% |
| 60% stock / 40% bond | -19.99% |
| 50% stock / 50% bond | -13.87% |
| 40% stock / 60% bond | -7.46% |
| 30% stock / 70% bond | -0.74% |
| 20% stock / 80% bond | +6.29% |
| Projected 10 year Cumulative return
after inflation (stock return 8% yearly, bond return 4.5% yearly, inflation 3% yearly [8]) |
|
|---|---|
| 80% stock / 20% bond | 52% |
| 70% stock / 30% bond | 47% |
| 60% stock / 40% bond | 42% |
| 50% stock / 50% bond | 38% |
| 40% stock / 60% bond | 33% |
| 30% stock / 70% bond | 29% |
| 20% stock / 80% bond | 24% |
The tables show why asset allocation is important. It determines an investor's future return, as well as the bear market burden that he or she will have to carry successfully if to realize the returns.
External links
- Asset Allocation
- Efficient Frontier
- Efficient Asset Allocation: Stocks or Bonds?
- Basic Concepts of Asset Allocation and Wealth Management Software
Footnotes
↑ Stock return from a Wilshire 5000 index fund; bond return from a Lehman Aggregate Bond Index fund; inflation data from US Treasury Department.
↑ Input parameters are for illustration purpose only; actual returns will vary.
References
↑ Gary P. Brinson, L. Randolph Hood, and Gilbert L. Beebower, Determinants of Portfolio Performance, The Financial Analysts Journal, July/August 1986.
↑ Roger G. Ibbotson and Paul D. Kaplan, Does Asset Allocation Policy Explain 40%, 90%, or 100% of Performance?, The Financial Analysts Journal, January/February 2000
↑ Thomas P. McGuigan, The Difficulty of Selecting Superior Mutual Fund Performance, Journal of Financial Planning, February 2006
↑ James Dean Brown, The coefficient of determination, Shiken: JALT Testing & Evaluation SIG Newsletter, Volume 7, No. 1, March 2003