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The process of allocating a portion of a total portfolio to various investment
selections is called asset allocation. The use of stocks, bonds, T-bills
and other sectional offerings is adjusted for present and perceived future
economic conditions AND the risk scenario of the investor. The assumption
is that the adjustment of more/less value to a given asset would outproduce/cause
less loss than another asset given the economic conditions.
STOCKS, BONDS, ALLOCATION AND STANDARD DEVIATION: (1993)
This initial simple analysis shows the risk (standard deviation) and the use of just stocks and bonds. As is clear, the addition of bonds- with less than a 1.0 correlation- reduces the risk over any time frame. However, return drops as well.
Asset Mix_______Return______________ Standard Deviation
|Stock/Bond Ratio||Expected Return||1 Year +- Horizon||5 Year+- Horizon||10 Year+- Horizon|
What does this mean? Hopefully the first two columns are relatively clear. The greater the amount of stock, the greater the overall past return. As you add more bonds, the return trends downward. The other three columns represent standard deviation- by how much, both plus and minus, the expected return might vary about 2/3rd's of the time. Over a one year horizon, for example, a 50/50 ratio of stocks and bonds is expected, from past history, to return 11%. But it could be 11% PLUS 11.8% (shown in the next column) or 22.8% or 11% MINUS 11.8% or a negative 0.8%. As time progresses, standard deviation is lowered (the formula is available elsewhere) so that over a five year period, a 50/50 ratios could expect 11.0% PLUS or MINUS 5.2%. All you therefore have to do in this simplistic risk exercise is to simply see what you would like to make and then see if you could handle the downside- though remember it could be MORE since one standard deviation represents only what might happen 2/3rds of the time.
If we take the analysis further, we consider the use of other/more non correlated investments to the allocation . This particular scenario assumes that the portfolio was not changed during a given year- i.e. the 60% of stocks and 40% bonds allocation was left for the entire year. And, for this review, the compound annual return was based on "rebalancing" at the end of each year. For example if a 60% stock/40% bond portfolio was, by value, 64% stock/36% bonds at the end of a year, 4% of stock value was sold and 4% of bond value was purchased to keep the ratio constant.
|Year||100% Stocks||100% Bonds||60% Stocks, 40% Bonds||1/3 Stocks, 1/3 Bonds, 1/3 Cash||BBK Index|
|Compound Annual Return||11.2||8.7||10.5||9.6||11.2|
|Number of years with positive return||15||14||16||17||17|
Stocks- S&P 500
Bonds- Long Term Treasury Bonds
BB&K Index- 20% U.S. Stocks, 20% Bonds, 20% Real Estate, 20% Foreign
Stocks, 20% Cash
Portfolios rebalanced each year.
Source Bailard, Biehl and Kaiser and Ibbotson Associates
Initially the stock portfolio appears to generate the highest return (exclude the BB&K index for the moment), but it does not address, by itself, the volatility or risk inherent in keeping everything in just one area (see section on risk for more detailed information). As evidence of that problem, review the high negative return on the purchase of stocks only in 1974. The 26.5% loss is unacceptable to most investors (most acceptable to those selling short or buying puts). But notice how this impact may be tempered by use of other investments that had a negative correlation (went up while other investments went down) such as the 1/3 stock, bond and cash allocation that had only a 5.4% loss.
And another allocation provides essentially the same outcome.
ASSET ALLOCATION 1986- 1994
|International Bonds Unhedged||0||0||10||0||10||0||0|
|International Bonds Hedged||0||0||0||0||0||10||10|
As you can see from the first column, the 60/40 split of stocks and bonds was second from the bottom in total return. Most importantly however was that it had the highest standard deviation (risk). Note that as you add different non correlated investments such as international stocks and bonds, the returns mostly went up. But equally as important was the fact that risk actually DECREASED.
Basic asset allocation uses perhaps just three investments- stocks based on the S&P 500 index, bonds based on long term treasury bonds and cash based on money market instruments. Most investors might use the simple rebalancing outlined above (changing for value at the end of a year), but many sophisticated methods are in use by professional managers and investors. One might tie an asset to underlying money/economic growth, or use more risky indexes/stocks as benchmarks (small capitalization stocks for example.) But as one tries to manipulate the allocation through these methods, one is trying to outguess the basic intent of asset allocation- keeping risk acceptable and avoiding the constant guessing which way the market would move at any point in time.
Additional assets may be added that are essential economic guides in today's marketplace. The BB&K index adds real estate and foreign equities to the allocation. Though real estate has been in the doldrums for many years, it is doing better most recently. Literally all managers are definitely suggesting a portion of foreign investments be included for almost all risk portfolios. The results are quite favorable- not only from the fact that the compounded annual rate of return matches the return for stocks alone, but that the risk at any given year has been reduced. While highs are lower, lows are lower and the odds of any year's return hurting an investor is much less significant.
Not all asset allocation meets conservative risk profiles. Managers may seek esoteric benchmark (small cap stocks for example) and use allocations consisting of unusual assets (oil, diamonds, coins,) and also try and time the market conditions and/or economic climate in an attempt to increase yields or returns. Such attempts are circumventing the intent of basic asset allocation strategies- that of keeping risk acceptable and not trying to time the market.
A review of asset allocation- as well as diversification, risk and other information provided herein- is absolutely critical in the analysis of the composition of a portfolio. If a broker/firm is utilizing only one or a few types of investments in a portfolio, one must ask, why? Not that it might be categorically wrong- in fact could be absolutely the right investment (defined solely by return) given a particular economic scenario- but what was the analysis that prompted such an singular allocation and lack of diversification? Was the use of a singular type of investment based on economic expectations or just pure happenstance without considerable forethought and knowledge. Equally important, what was the risk as defined by beta or standard deviation?
A review of investments in context with an entire portfolio involves the "know thy client" rule and suitability. Brokers must be aware of the diversification necessary as well as the odds of trying to beat a simple asset allocation system through the purchase of higher risk individual issues or by trying to outguess the system. An arbitrator MUST maintain an overview of basic investment strategies and ascertain whether the customer could accept (or was even aware of) the higher risk through the use of these other strategies.