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Chapter 1 What is Asset Allocation?
Chapter 1
What is Asset Allocation?
As explained in the Introduction, asset allocation is defined as
the process of dividing investments
among different kinds of asset categories. This process is done
as part of a larger plan or strategic
asset allocation. Strategic asset allocation involves the
decision making process in order to
determine the asset allocation mix, time horizon, and objectives
associated with an investment
plan. Once this process includes, periodic review takes place to
rebalance allocation percentages
in order to ensure the plan is proceeding as intended. This
approach to asset allocation and
investment planning is a passive one that does not necessarily
produce wild returns in a raging bull
market but more often than not, it protects an investors
downside when the market experiences
prolonged periods of economic downturns.
In 1986, economist Gary P. Brinson, along with his colleagues L.
Randolph Hood and Gilbert L.
Beebower released a landmark 10-year study of investment
performance for 91 pension funds
managed by SEI Investments. Entitled, Determinants of Portfolio
Performance and appearing in
the July/August 1986 issue of the Financial Analysts Journal,
the study sought to answer the
following questions concerning the factors that determine the
performance of an investment fund:
(1) How much of an investment portfolios return is attributable
to investment policy; (2) How
much of a portfolios return is attributable to differing
investment policies; and, (3) How much of
a portfolios return is tied to its benchmark index. Figure 1
illustrates the variability of returns as
shown by Brinson.
Figure 1: Variability of Returns Mutual Funds (Active) vs.
Pension Funds (Passive)
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Chapter 1 What is Asset Allocation?
2
Figure 1 illustrates the variability of returns between funds on
the lower end of the scale or 5th
percentile of a time-series regression scale (the far left hand
side of the y axis) and those in the
95th percentile (represented on the right hand side), comparing
mutual funds, which are actively
managed, and pension funds which are not as actively managed.
The results show a wider disparity
for mutual funds between the 5th percentile and 95th percentile
than pension funds. This further
shows that adherence to an investment policy, based on asset
allocation, has the greater influence
on investment returns over market timing or securities
selection.
Brinson et. al. looked at the effects an investment funds
policy, the period in which an investment
is made, and the selection of individuals securities, had on a
portfolios total return. In further
consideration of the range of returns between the percentiles,
according to the Brinson study the
variability of returns between the 5th percentile or poorer
performing funds and the 95th percentile
or top-tier performing funds ranged from 46.9 percent to 94.1
percent for mutual funds and 66.2
percent to 97.2 percent for pension funds. The tighter range for
pension funds can be attributable
to a greater adherance to investment policy in terms of
strategic asset allocation than with mutual
funds, which are more actively managed and have a higher
turnover ratio.
Table 1: Comparison of Investment Returns (Policy versus
Strategy), 1974 1983
Average Return Standard Deviation
Policy 10.11% 0.22%
Policy and Timing 9.44 0.52
Policy and Selection 9.75 1.33
Actual Portfolio Returns 9.01 1.43
Investment policy is the biggest determinant with respect to an
investments return. The
information provided in Table 1 more than suggests that a
reliance on establishing an investment
plan based on long term investment goals, objectives, and risk
tolerance produces better returns
than a portfolio based on both investment policy and market
timing, investment policy and security
selection or the portfolios actual returns.
In Figure 2 (as well as in Table 1), there is little variance
from the average return for a portfolio
based on investment policy (0.22 percent) as oppose to a
variance from the average of 1.43 percent
for the portfolios actual returns.
The investment returns based on investment policy were 0.67
percent higher than those returns
based on both investment policy and market timing; policy
returns were 0.36 percent above those
based on policy and investment selection; and, investment policy
returns were 1.10 percent more
than those based on the portfolios actual return (Table 1 and
Figure 2).
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Chapter 1 What is Asset Allocation?
3
Figure 2: 10-Year Average Annual Investment Returns, 1974
1983
Understanding the determinants that drive investment return is a
key part of understanding the
importance of asset allocation and how it is employed to shape
an investors portfolio. It is well
established that the thought and effort that goes into
determining an individuals investment policy
weighs heavily in the overall results of their investment
return.
Determining Asset Mix
Part of the consideration that goes into employing asset
allocation is the selection of securities to
be placed in the plan. The Chapter 3 and the Index to this book
provide a list of different asset
allocation portfolios based on varying mixes of asset classes
(as discussed further in this chapter).
The type of investor that you are and your aversion to risk will
dictate the mix of assets within
your investment portfolio.
It is important to understand the historical returns of various
asset classes (i.e. cash, bonds, and
stock), in order to properly determine the appropriate asset
mix. Knowing the returns of differing
asset classes will help to bring more clarity to the risk
pyramid, which appeared in the Introduction
section.
Average Return
Standard Deviation
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Chapter 1 What is Asset Allocation?
4
Investment Returns by Asset Class
As has been discussed, there are different rates of return for
different levels of risk. This is the risk-
reward trade off discussed in the introduction. As we move up
the investment pyramid, we find a
higher expected return for options, derivatives, real estate and
other alternative investments over
stocks, bonds, and cash and cash equivalents.
The basis for this trade-off can be found in the historic
returns of the major asset class categories,
cash, bonds, and stock. As you can see demonstrated in the
risk-reward pyramid, there is a direct
relationship between risk and reward. If you are wiling to
stomach the inherent volatility associated
with investing in the stock market, you should be rewarded with
a higher investment return than if
you put your money in a relative risk-less investment such as
cash and cash equivalents such as
3-month U.S. Treasury bills.
Inflation
To evaluate the importance of asset allocation, it is helpful to
take a look at the difference returns
for different asset classes versus inflation. We begin by
looking at the rate of inflation for the 25-
year period between 1983 through 2007. The rate of inflation is
based on the Consumer Price Index
(CPI) for urban consumers, which is a fairly accurate measure of
rises in consumer prices (Table
3).
Table 3: Historical Rate of Inflation, 1983 2008
Year CPI-U Year CPI-U
1983 3.2% 1996 3.0
1984 4.3 1997 2.3
1985 3.6 1998 1.6
1986 1.9 1999 2.2
1987 3.6 2000 3.4
1988 4.1 2001 2.8
1989 4.8 2002 1.6
1990 5.4 2003 2.3
1991 4.2 2004 2.7
1992 3.0 2005 3.4
1993 3.0 2006 3.2
1994 2.6 2007 2.8
1995 2.8 2008 3.8
Retrieved from
http://www.usinflationcalculator.com/inflation/historical-inflation-rates/
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Chapter 1 What is Asset Allocation?
5
CPI is an important measure to gauge investment results.
Investments that fail to produce an
investment return that is at least as high as the prevailing
inflation rate loses to purchasing power.
The concept is an easy one to grasp: imagine that you loan
$1,000 to a friend today and they offer
to options to pay the money back. In the first option, the
friend offers to pay the $1,000 back to
you in five years, at five percent interest per year. Option 2,
the friend pays you back $1,000 at the
end of the year. Which would you prefer?
Although you may be inclined to take the money at the end of a
year (as most people would), the
better option is to take the money five years from now. Waiting
five years will give you a total
amount of $1,276.28. Assuming that the historic annual rate of
inflation is 3.41 percent, the value
of $1,000 in 5 years is eroded to $845.64. The value of $1,000
in five years at 3.41 percent
appreciates to $1,182.53. If your friend only paid you $1,000 in
five years, you would lose $336.89
in purchasing power due to inflation. Conversely, if your friend
pays you a compound interest of
five percent, you would be ahead of inflation by $93.75.
Investments that earn less than inflation are more susceptible
to inflation or purchasing power risk.
This is why we seek investing alternatives that allow our money
to grow at a pace that is at least
as high if not higher than inflation. Different asset classes
clearly have different rates of return.
Our goal is to minimize the risks associated with investing and
maximize our return, adjusted for
inflation (and taxes, although for the moment, we will leave
that discussion to the side). To do that,
we want to adopt a process of allocating assets accordingly
among different asset classes in order
to accomplish this goal.
Asset allocation helps us achieve our investing goals in that it
takes advantage of the variability of
returns as we set policy for investing and clarifies what we
seek to accomplish. This becomes more
evident as we see the different historical returns and cash,
bonds, and stock and carry this theme
into Chapter 3 when looking at the Modern Portfolio Theory and
other determinants that go into
establishing investment policy.
Cash
Cash is deemed the safest place for your money, when held in a
money market instrument such as
U.S. Treaury bills, certificates of deposit, repurchase
agreements and commercial paper. For the
average investor, access to the money market comes by way of
money market funds, U.S. Treasury
bills and Treasury Inflation Protection Securities (TIPS).
A money market fund is one specifically designed to provide a
stable vaue of $1. The problem
however is that while your money sits in a money market funds,
it loses to the opportunity cost of
investing it in some other instrument with a greater potential
for gain. Your biggest risk in a money
market fund is inflation risk. This can be combatted by going
directly into U.S. Treasury bills
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Chapter 1 What is Asset Allocation?
6
Table 4: Historical Investment Returns Cash*, 1983 2008
Year Yield Year Yield
1983 8.62% 1996 5.01%
1984 9.54 1997 5.06
1985 7.47 1998 4.78
1986 5.97 1999 4.64
1987 5.78 2000 5.82
1988 6.67 2001 3.40
1989 8.11 2002 1.61
1990 7.50 2003 1.01
1991 5.38 2004 1.37
1992 3.43 2005 3.15
1993 3.00 2006 4.73
1994 4.25 2007 4.36
1995 5.49 2008 1.37
Retrieved from
http://www.federalreserve.gov/datadownload/Build.aspx?rel=H15
*Based on the annualized secondary market discount rate on the
3-month U.S. Treasury Bill
We can measure investment returns on money market funds by
looking at the investment yields
on the 3-month U.S. Treasury bill trading in the secondary
market (for the sake of establishing
concepts, we will defer a discussion on markets and investment
principles for later in this book).
Based on the annual yields published by the Federal Reserve for
the 25-year measuring period
(Table 4), you can see that money market funds have outpaced
inflation, except for the period
between 2002 2005, which may be attributable to the effects of
the Iraqi War.
One myth that should be debunked is that of a riskless
investment. It is thought that since cash
and casj equivalents, such as money market funds, closely mirror
or outpace inflation, this asset
class represents a riskless investment. Although there is
credence to the argument that you are not
subject to the same types of risks associated with investing in
other asset classes, you are still
subject to purchasing power risk, as evidenced in the 4-year
period between 2002 and 2005.
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Chapter 1 What is Asset Allocation?
7
Bonds
Table 5: Historical Investment Returns Bonds*, 1983 2008
Year Yield Year Yield
1983 11.18% 1996 6.71%
1984 12.41 1997 6.61
1985 10.79 1998 5.58
1986 7.78 1999 5.87
1987 8.59 2000 5.94
1988 8.96 2001 5.49
1989 8.45 2002 5.43
1990 8.61 2003 4.96
1991 8.14 2004 5.04
1992 7.67 2005 4.64
1993 6.59 2006 4.91
1994 7.37 2007 4.84
1995 6.88 2008 4.28
Retrieved from
http://www.federalreserve.gov/datadownload/Build.aspx?rel=H15
*Based on the annualized market yield on the 30-year U.S.
Treasury Bond. Note that the 30-year bond was discontinued on
February 18, 2002 and
reintroduced February 9, 2006. The 20-year U.S. Treasury Bond
yields were adjusted for that period to reflect the nominal yield
on the 30-year
bond for the period
(www.treas.gov/offices/domestic-finance/debt-management/interest-rate/ltcompositeindex_historical.shtml).
Bonds provide a higher investment yield than cash. The
investment yields on bonds are measured
by the nominal rate offered on the 30-year U.S. Treasury bond.
Given the long-term nature of these
rates they tend to be indicative of overall rates for all fixed
income securities. Table 5 provides the
published yields for the period 19832008.
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Chapter 1 What is Asset Allocation?
8
Stocks
Table 6: Historical Investment Returns Stocks*, 1983 2008
Year Return Year Return
1983 22.56% 1996 22.96%
1984 6.27 1997 33.36
1985 31.73 1998 28.58
1986 18.67 1999 21.04
1987 5.25 2000 -9.11
1988 16.61 2001 -11.89
1989 31.69 2002 -22.10
1990 -3.11 2003 28.68
1991 30.47 2004 10.88
1992 7.62 2005 4.91
1993 10.08 2006 15.79
1994 1.32 2007 5.49
1995 37.58 2008 -37.00
Retrieved from
http://1.bp.blogspot.com/_C0Jf4qaV4-8/SYQO9ftlppI/AAAAAAAAAH0/oCx7z3stdkg/s1600-h/1980-
2008_stock_market_returns.JPG
*Based on the Standard & Poors (S&P) 500 Composite
Index
Stocks represent the highest level of return, relative to risk.
There are many factors that go into a
stocks investment return that can be segmented by company,
industry, market sector, region,
country, and other variables. Because these factors represent
both systematic and non-systematic
risks, you can stand to lose as much, if not more, than what you
stand to gain investing in stocks.
Table 6 represents the returns for the Standard and Poors
(S&P) 500 index for the 25-year period.
We chose the S&P 500 index because it is often cited as the
best predictor of market movement.
We could have just as easily chosen the Russell 2000 or Wilshire
5000 indices, which are broader
based measures of the stock market but the accuracy of the
S&P 500 as a benchmark is suitable
for comparative purposes in this book.
What you see in Table 6 that differs from the rate of inflation
and returns shown for cash and bonds
for the same period is the introduction of negative results. The
greater potential investment returns
that you seek, the greater the risk you should be willing to
take.
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Chapter 1 What is Asset Allocation?
9
Figure 3: Comparison of Asset Class Returns versus Inflation,
1983 2007
Figure 3 shows that the variability in returns for equities such
as stocks is far greater than it is for
other asset classes and that there are far greater external
influences that affect the way in which
stocks move than cash and bonds. This is important to know
because for the purpose of investing,
stocks give you the greatest potential return on your investment
in the asset class, but also expose
you to the greatest amount of volatility or risk of loss.
Over the long-term we know that stocks (and specifically the
sub-asset class small-cap stocks)
return a much higher annual rate of return than either cash or
bonds. According to the Ibbotson
Associates yearbook figures for rates of return by asset class,
the annual average rate of return for
small-cap stocks is 17.5 percent, followed by large-cap stocks
at 12.4 percent. Bonds came in at
around 5.5 to 6 percent and inflation was 3.1 percent (Figure
4).
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Chapter 1 What is Asset Allocation?
10
Figure 4: Historic Rates of Returns (Compound Annual Rates of
Return 1926-2003)
Inflation (CPI-U) 3.1%
Intermediate-Term Government Bonds 5.6%
Long-Term Government Bonds 5.8%
Long-Term Corporate Bonds 6.2%
Large-Cap Stocks 12.4%
Small-Cap Stocks 17.5%
Source: 2004 Ibbotson Associates, Inc. All rights reserved.
Certain portions of this work were derived from copyrighted works
of Roger G. Ibbotson and Rex Sinquefield.
We can further compare the historic returns for various asset
classes. Ibbotson Associates, Inc.,
which is a wholly owned subsidiary of Morningstar, Inc.,
publishes an annual yearbook on
investing and different investment asset classes entitled
Stocks, Bonds, Bills, and Inflation
Yearbook. In the 2004 yearbook, the historic returns for the 70+
period between 19262003 closely
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Chapter 1 What is Asset Allocation?
11
mirrored the asset class returns vis--vis inflation that are
illustrated in Figure 3 (Table 7 and Figure
5).
Table 7: Historical Investment Returns By Asset Class, 1970
2004
Asset Class Compound Annual Return Standard Deviation
Commodities 12.38% 19.88%
U.S. Stocks 11.22 17.23
International Stocks 11.09 22.45
International Bonds 8.76 8.83
U.S. Treasury Bonds 8.74 7.05
Treasury Inflation Protection Securities (TIPS) 8.25 11.74
U.S. Treasury Bills 6.27 3.00
Inflation (CPI) 4.74 3.18
Source: 2006 Ibbotson Associates, Inc. All rights reserved.
Figure 5: Historical Investment Returns By Asset Class,
1970-2004
Source: 2006 Ibbotson Associates, Inc. All rights reserved.
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Chapter 1 What is Asset Allocation?
12
How Asset Allocation Influences Investment Results
Reducing Risk and Maximizing Profits
Asset allocation works in helping balancing the differences in
asset classes, in order to produce a
return that respects the risk profile of the investor. This
balancing of risk produces a relative rate
of return for a given level of risk that the investor is willing
to accept (this is discussed more in
Chapter 2).
There are 2 broad categories of risks that affect securities and
investments, systematic and non-
systematic risks. Systematic risk affects all securities across
within an asset classes, sub-classes
and sector without regard to a specific issue or security. It is
also referred to as market or un-
diversifiable risk. Non-systematic risks, which are referred to
as specific or diversifiable risk,
affects a particular security.
The different types of systematic risks include:
Interest-rate risk the risk that the value of securities will
drop because of a drop in the
underlying rate of interest. When interest rates rise, the
prices on bonds when issued are low
but interest rates are higher than those on similar bonds that
were issued previously. This is
done as a way to encourage new bondholders to invest in the
issue but has an adverse affect on
existing bondholders since the value of their bonds fall. This
risk not only affects fixed-income
securities such as bond but also affects utility stocks and
preferred stock issued by a corporation
since both types of securities are most affected by changes in
interest rates.
Inflation risk the risk that the value of your money dollars is
eroded by the general rise
in prices for goods and services. Also referred to as purchasing
power risk, inflation risk
requires you to earn an investment return that is at least as
high as the rate of inflation The
current annual long-term rate of inflation, as measured by the
consumer price index, since 1912
is 3.41 percent, according to the Bureau of Labor Statistics. An
investment earning less than 4
percent has a lower purchasing power since its return has not
out-paced inflation.
Currency risk this risk affects the value of currency, arising
when a change in value occurs
between different currencies. For example, lets say that a
business is operated that trades
internationally where the business owner is paid in U.S.
currencies based on prevailing Euro
exchange rates. The concern of the business is the strength of
the U.S. dollar falls against the
Euro. A contract that pays me 2.5 million Euro where the dollar
is at 80 cents to the Euro
would be denominated in U.S. dollars at $2 million USD. If at
the inception of the contract
U.S. dollars and the Euro were at par with each other, $500,000
was lost due to currency risk.
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Chapter 1 What is Asset Allocation?
13
Liquidity risk the risk that a security may not have a ready
market for me to sell, causing me
to lose to opportunity cost. Liquidity risk occurs when you have
a security to sell but no buyer
to match up with. Companies that are closely held, start-ups,
and have small market
capitalization are more susceptible to liquidity risk. This risk
effects all securities such as
stocks and bonds.
Political risk the possibility that political unrest or a change
in the government of another
country that you invest in will cause the value of your
investment to become worthless. Such
events as war, terrorist attacks, regime change and other
political unrest may cause a new
government to cease financial assets invested in the country or
a deposed leader to plunder his
or her countrys national treasury, causing the value of any
securities issued to plummet.
Political unrest can also affect the value of securities issued
by foreign companies doing
business in a country with political unrest.
Where systematic risks cannot be diversified and impact the
entire market, non-systemic risks are
specific risk that is particular to an asset class, sub-class or
sector. Non-systematic risk includes
the following types of risks:
Management risk management decisions and other actions of a
company that can have an
impact on the companys stock or other securities issues and
cause an investor to lose value.
For example, it was disclosed in late 2008 that many U.S. banks
were heavily leveraged in
what were termed toxic assets, which were bets on repackaged
subprime mortgages. These
instruments, known as credit default swaps and credit default
obligations were a highly
complex securitized form of debt that paid high interest rates
based on the poor credit ratings
of borrower who took out the underlying loans. As these home
mortgage defaults began to rise,
many of these hybrid securities blew up, causing the balance
sheet of many banks to take a big
hit, precipitating one of the worse financial crisis in this
country since the Great Stock Market
crash of 1929.
Credit risk is a risk that affects the creditworthiness of a
bond issuer. The investors chief
concern is that the bond issuer will be unable to meet their
obligation to make regular interest
payments due this may be due to some financial difficulty that
the issuer is experiencing.
The different systematic and non-systematic risks are summarized
in Table 8.
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Chapter 1 What is Asset Allocation?
14
Table 8: Systematic and Non-Systematic Risks
Systematic Risks (Market Risks; Un-Diversifiable Risks)
Interest-Rate Risk Changes in prevailing interest rates affect
the value
of your investment
Inflation Risk (Purchasing Power Risk) Also known as Purchasing
Power risk; affects the
buying power of your investment
Currency Risk Compares the value of 2 currencies and how
changes in 1 impacts the other
Liquidity Risk The risk that a market is unavailable to sell
a
security
Political Risk Changes in regulations or political unrest and
their
impact on the value of your investment
Non-Systematic Risks (Specific Risks; Diversifiable Risks)
Management Risk Decisions made by the management of a
particular
company and its impact on the value of the
companys securities
Credit Risk (Default Risk) A fear that the creditworthiness of a
company or
other issuer may fall and render the investment
worthless
Reinvestment Risk An inability to replace a security that has
been
called by the issuer with another of comparable
value
There is more on risks provided by the Financial Industry
Regulatory Association, Inc. (FINRA)
in Appendix 2. FINRA is the merger of the NASDR, Inc. and New
York Stock Exchange
regulatory arm in 2008. The information provides a good primer
on managing risks and introduces
much of the discussion we have had here regarding the inherent
tension that exists between risk
and return among different asset classes.
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Chapter 1 What is Asset Allocation?
15
Chapter Summary
We began this chapter with a look at what asset allocation is,
looking at the work conducted by
Gary Brinson et.al. and Roger Ibbotson. Brinson and Ibbotson
showed that the variability or
changes in investment returns was due more to the investment
policy established by the investor,
more than timing the market or the selection of assets within
the portfolio or fund. Understanding
the importance that investment policy plays in determining how
to create an investment portfolio
leads to the process of asset allocation.
Determining the assets mix that is appropriate begins with
taking a look at the historic returns for
various asset classes, including inflation. We use inflation as
a base line for all investment returns
since the purchasing power of money is eroded over time due to
inflation risk. Looking at the rate
of inflation, as measured by the consumer price index, against
benchmark measures for cash (3-
month U.S. Treasury Bill), bonds (30-year U.S. Treasury Bond),
and stocks (Standard and Poors
500 Index) for the period 1926-2003 we see the following
annualized returns:
Asset Class Benchmark Measure Historic Return
Inflation Consumer Price Index (CPI-U) 3.1%
Cash 3-month U.S. Treasury Bill 4.0%
Bonds 30-year U.S. Treasury Bond 5.8%
Stocks S&P 500 12.4%
Source: 2004 Ibbotson Associates, Inc. All rights reserved.
Asset allocation strikes a balance between returns and
volatility, which is the risk of loss. In
striking this balance, an investor needs to consider the impact
different types of risks have on the
investment returns that they receive. Risks can be classified in
1 of 2 ways, as being systematic
risks and non-systematic risks. Systematic risks, also known as
market risks, are those risks that
affect all asset classes regardless of type. Systematic risks
include inflation risk, interest-rate risk,
and political risk. Systematic risks cannot be reduced through
diversification.
Non-systematic risks are those that are specific to a security
or particular investment. Known as
specific risks, non-systematic risks include management risk and
credit or default risk. Non-
systematic risks can be dealt with by varying the percentage of
holdings in any one type of security
or asset class (including sub-asset class as listed in Appendix
3).