DIVERSIFICATION AND PROBABILITY OF RETURN

To be considered a credible wrap account, the program has to offer asset allocation. This in itself requires definition. A singular purchase of stock does, quite obviously, not represent a diversified portfolio. To have proper diversification, a portfolio should have between 10 to 15 stocks to insulate itself from unsystematic risk- that is the risk of one company having a problem irrespective of the overall market (Digital or IBM for example). For such purposes, an adviser should recommend 13 stocks to diversify a pure stock portfolio. But stocks, by themselves, do not represent the entire spectrum of investment considerations. Corporate bonds, treasury instruments, municipals bonds and money market funds comprise a selection of investments in a "truly" diversified portfolio representing all types of investments (remember that the purchase of bonds also must be diversified- though municipal bonds are not generally used in wrap accounts). The use of the various investments within one account is called asset diversification. In such a portfolio, the addition of bonds and money instruments insulates the pure stock account from uneven economic (called market or systematic risk) events that would cause that section of the fund to go down. This results from the general historic fact that if stocks are doing poorly, some other section of investments is doing well. Proper allocation of the investments, in accordance with a clients acceptance of risk, should allow the investor an acceptable return considering these conditions. Of course, the investor is seldom, if ever, able to hit a home run in overall return, since of the categories mentioned so far- stocks, bonds and money market funds- only stocks would normally provide substantial gains in value. Bonds and money instruments are less volatile and, by nature, unable to gain in value to the same degree of stocks and hence would insulate the account from the potential substantial gains as well. The difference in returns is shown on an historical level in the following chart.

RETURNS OF STOCK, BOND, AND T-BILLS

Compounded Annual Return 1926- 1988

Standard Deviation 1926-1988

Socks (S&P)	10.0%	21%
Long Term US Bonds	4.4%	13.0%
T- bills	3.5%	0
Equal Mix Stocks/Bonds/Bills	6.5%	12.0

The first column addresses the type of returns an investment would present to a client as the major reason stocks must be an active part of a portfolio. Over the 60 year period, stocks unquestionably earned the highest return. The second column reflects the increased returns that became available through the use of bonds. However, to be clear in its understanding, the reader must realize that a substantial portion of the gain was due to the reduction of interest rates in the mid/late 80's from the exceedingly high rates of the early 1980's. The third column, for ease of definition of understanding and use, reflects the volatility and short term risk of the various investments. Stocks are known to have periods of significant decline- probably best noted by the October 1987's Black Monday. Bonds have also shown a considerable volatility as of late and may also pose a risk hazard. When viewed in the short time frame, the odds of losing or making money may be more than the investor is willing to accept or should accept. However, a properly managed combination of all three investments (usually all three are used, but is not a requirement. Less money market funds, if any, are used in periods of strong growth ) can reduce the overall risk of a singular purchase of only one investment and still provide the investor with acceptable returns. Obviously, the less risk or the more conservative portfolio, the less the return- considering a normal market and expertise of the manager.

If a client wanted a very conservative portfolio (still with the realization that stocks are necessary for the major growth to the portfolio), then the following percentages might be utilized:

Short term debt (T-bills) 50%

Long Term Bonds (T-Notes or Bonds) 25%

Equity (Stocks) 25%

If the short term bills are at 6%, long term bonds at 8% and stocks at 11%, the expected return on the account would be a weighted average of the returns

T bills	6% x 50% = 3%
T-Notes and Bonds	8% x 25% = 2%
Stocks	11%x 25%= 2.75%

Expected total return 7.75%

This return is realistic over the long term, but due to the volatility of the bonds and stocks, the short term range could be from -.75% to 16.25%.If the client was willing to take a slightly more aggressive approach, the following grouping of investments would return:

Short Term Debt (T- Bills) 33%

Long Term Bonds 33%

Stocks 33%

The expected return would be

T bills	6% x 33% = 2%
T-Notes and Bonds	8% x 33% = 2.65%
Stocks	11%x 33%= 3.65%

Expected Total Return 8.30

The overall volatility would increase and the short term returns would statistically range from -3% to 19.50%. If the clients would accept a more aggressive approach- perhaps keyed to a longer time horizon, the mix of the portfolio might yield:

T bills	6% x 15% = .90%
T-Notes and Bonds	8% x 20% = 1.60%
Stocks	11%x 65%= 7.15%

Total Expected Return 9.65%

But as expected, the volatility would increase substantially due to the higher use of stocks. Overall, the return would be -6.6% to 25.90%

Wrap accounts however have been increasing in numbers as well as sophistication. Such accounts now consider not only the standard domestic income, balanced and growth accounts but international accounts as well. But the more esoteric the investments become, the greater the potential risk for lower returns and the greater the capabilities of the manager is required.