This is a form of diversification in that you are "not putting all your eggs in one basket". But the definitional use as "diversification" is really a misnomer since the concept really involves the use of different assets that do not move in direct correlation with each other. The movements of one class of assets may be somewhat offset by the non correlated movement of a different class of assets. The intent is not necessarily to increase return as much as it is to find the accepted rate of return while simultaneously reducing risk or maintaining it at a predefined level.
There are at least three methods of asset allocation. The first is called strategic asset allocation. It means that once the type and percentages of assets have been chosen, they do not change. That is not to say that you don't rebalance each year, but you simply don't make further adjustments as to the economy or any other factor. For example, once you decide on 20% international stock, that decision is never altered.
The second type is tactical asset allocation. This involves a periodic revision of the asset mix in order to improve returns, adjust for risk or both. It definitely requires more time and effort in order to evaluate the economic environment, market conditions and specific investments.
The third method is referred to as dynamic asset allocation and may be primarily geared to the institutional investor. As the portfolio loses value, the more risky assets are sold to buy assets that are risk free. On the other hand, as the market rises, less risky assets are sold and more risky- and hopefully more appreciation oriented- investment are bought.
Per professors Stine and Lewis, "the passive portfolio must be rebalanced to maintain a level of risk exposure consistent with the investors objectives. In most cases, the investor would be advised to rebalance only when the portfolio reaches a predetermined level of risk exposure rather than to make adjustments on a calendar basis. This has the advantage of producing a narrower range of possible stock weights and, in most cases, requires fewer rebalances. This was shown to hold over investment horizons of 3, 5, 10, 15 and 20 years. A reasonable strategy is to rebalance whenever the stock weights vary 7.5% to 10% from their original position. This strategy does better than annual rebalancing. However, if the portfolio manager elects to follow a calendar strategy, rebalancing quarterly or semi-annually is too frequent and the annual rebalancing strategy appears to produce the best result".
Undoubtedly one can determine any number of types. Astute investors would utilize continual monitoring not only of the fund characteristics itself (manager changes, expenses, size, etc.), but the national and international economy. As stated ad infinitum, material from the Federal Reserve Boards is mandatory.
STOCKS, BONDS, ALLOCATION AND STANDARD DEVIATION: (1993)
Asset Mix_______Return______________ Standard Deviation
|Stock/Bond Ratio||Expected Return||1 Year +- Horizon||5 Year+- Horizon||10 Year+- Horizon|
What's that all 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. So what are the other three columns? They 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.
ASSET ALLOCATION 1986- 1994
|International Bonds Unhedged||0||0||10||0||10||0||0|
|International Bonds Hedged||0||0||0||0||0||10||10|
So, what's your pleasure? 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.
|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
Look at the first and last columns. The first is the simple S&P 500 index. Not a bad return at 11.2% but look at the highs and the lows of each year. They really bounced around. Now look at the last column of 20% stocks, bonds, cash, foreign stocks and real estate. It's a no brainer make up and it also did 11.2%. But look at the fluctuations between the returns of each of those years to that of the S&P. Far LESS volatility. Isn't that what you want? A good return with potentially lower risk than that of the marketplace by itself. And it can be done by using various investments.
MUTUAL FUNDS: In context with definitions on correlation is the issue of how many funds you should own. Professors at the University of Southern Mississippi reviewed the market between 1978 and 1989. As is evidenced in basic asset allocation, risk is reduced by adding more funds- various correlations. But they also showed that you did not need a great number of funds since 75% of the risk reduction is brought about by the use of just 4 funds. After 8 funds, a further reduction of risk was almost futile and after 15 funds there were none. The authors decided that one should put monies into six various groupings of growth and value funds each with an individual focus on small, mid cap and large companies. Add in a couple of foreign funds and they suggest you are done. Quite possible for equity accounts. For true diversification, you would also include some bond funds- mid term and high yield with a potential for long term corporate. For the more adventurous, you might consider some sector funds. So, in total, there might be 10 to 12 funds for a big player with full asset allocation. For those wanting pure equity, I'd agree with around 6 or so.
ASSET ALLOCATION 1993
Source: Kiplinger article
|Vanguard Small Cap Index||15%||1.1%||18.7%|
|Vanguard 500 Index||15||2.7||9.9|
|T. Rowe International Stock||15||1.6||40.1|
|Scudder International Stock||15||6.3||15.8|
|Benham Treasury Note||15||5.4||7.9|
|Klexington Gold Fund||10||0.2||6.0|
|U.S. Government Securities||15||3.5||3.3|
Beta of Portfolio = 0.38
Look at this carefully. This is another no brainer allocation and the use of non correlated (better phrased as randomly correlated) investments. The two international funds undoubtedly were in different areas- Pacific and Europe for example. And obviously, in hindsight, you wish that you had just picked the T. Rowe investment only and certainly none of the U.S. Government securities. (Isn't hindsight investing fun?!) But look at the return overall. 15.0% That's 1/3rd better than the 500 Index. But that's not all. The article said that the beta was only .38. So you got 1/3 more return than the marketplace with about 2/3rd's less risk. The article did not provide the analysis for the beta (and it seemed awfully low and I wanted corroboration) so I just usually say to students- assume you got a 15% return with just half the risk of the market. Wasn't that still good?! How about a 10% return with 2/3rd's the risk. Isn't that still the intent of asset allocation? Of course!!
Lastly, and remember this as well, a study by Brinson, Hood and Beebower of the quarterly returns of 91 large pension funds between 1974 to 1983, compared the returns from the asset classes they were investing in. 93.6% of the volatility was explained by the movements In the underlying asset classes they were investing in. They also showed that active managers, in the aggregate, underperformed the benchmarks by 1.10% a year. In other words, the active selection of stock did essentially little to nothing to the overall return- it was where the money was invested that made the difference.
A Study by Ibbottson in 1995 noted that 91.5%of the volatility were due to the allocation of funds. That simply reinforces the earlier study. So, use either number- they both show that the ability to pick the individual stocks or to try market timing is effectively a waste of time.
As Roger Gibson noted in his book, "Asset Allocation: Balancing Financial Risk", "traditionally, money management has been equated with security selection and market timing. Ironically, it is because of the tremendous intelligence and skill of the investment professionals engaging in these activities that the probability is so low. Yet, the choice of asset category and their respective weights in a portfolio has had, and will continue to have, a large impact on future performance. To many, it is surprising that over time, investment policy decisions regarding the choice of investment asset categories and their relative long term weightings have a much greater impact on their portfolios future performance than does the shifting of money among the asset categories and the selection of securities within asset categories".
It is the asset classes that one picks that determines how well one might do. Not stock picking. Not market timing.
BONDS AS PART OF ASSET ALLOCATION: (Ticker 1999) "In the past 36 years, one could have received 88% of the market's return with only 67% of the volatility by maintaining a 60/40 split between the S&P 500 and the five year T-Bond." Of course with today's high flying returns and low interest rates, I would opt for a heavier weighting to stocks. But it always pays to be vigilant and wary.
See The Guide to Asset Allocation
Asset Allocation- (NY Times ) Over the last 10 years through April 30 1999, the returns of a portfolio that was 50 percent invested in the Wilshire 5000, a broad stock index, and 50 percent in cash would have been 11.5 percent, annualized, or 6.2 percentage points less than a pure equity portfolio.
"Over the last decade, a fixed-allocation portfolio that was 41% in stocks and 59% in United States government bonds, for example, would have been no more risky than the half stocks-half cash portfolio. Yet it would have returned 12.5% annualized, or one percentage point more.
Asset Allocation based on the Sharpe Ratio (2000) This interactive demo shows how the Sharpe Ratio is used to find a portfolio that provides a maximum rate of return for a given risk tolerance. But if you had used this format, you would have used bonds during a time when we had the greatest bull market ever. The statistics used for the standard deviation belied what was actually going on. Hence one more reason why you need to do the analysis but also why the result lacks real life application
Allocation and risk (Glenn Kautt 2005) If your portfolio is diversified enough to reduce or eliminate unsystematic risk, you may think you can benchmark performance using multiple indices. In theory, it should like a great idea, but the practical application is problematic. These indices simply do not exist. There are no indices for an individual stock, bond, option , future, specialty fund, real estate or any subset of specific in your portfolio. Using any individual index as a benchmark for a properly diversified portfolio will give you little practical information on total risk- adjusted performance or investment efficiency.
DO YOUR HOMEWORK IN ANALYZING NATIONAL AND INTERNATIONAL ECONOMIC FUNDAMENTALS. THAT'S WHAT WILL DETERMINE YOUR SUCCESS.