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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)
Policy
Policy and Timing
Policy and Selection
Actual Portfolio Returns
Average Return
10.11%
9.44
9.75
9.01
Standard Deviation
0.22%
0.52
1.33
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).
Average Return
Standard Deviation
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.
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 25year 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
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
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
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.
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
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.
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
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.
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).
Inflation (CPI-U)
3.1%
5.6%
5.8%
6.2%
Large-Cap Stocks
12.4%
Small-Cap Stocks
17.5%
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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Standard Deviation
19.88%
U.S. Stocks
11.22
17.23
International Stocks
11.09
22.45
International Bonds
8.76
8.83
8.74
7.05
8.25
11.74
6.27
3.00
Inflation (CPI)
4.74
3.18
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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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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.
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Interest-Rate Risk
Inflation Risk (Purchasing Power Risk)
Currency Risk
Liquidity Risk
Political Risk
Management Risk
Reinvestment Risk
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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Benchmark Measure
Consumer Price Index (CPI-U)
3-month U.S. Treasury Bill
30-year U.S. Treasury Bond
S&P 500
Historic Return
3.1%
4.0%
5.8%
12.4%
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. Nonsystematic 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).
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