Asset Allocation
I really am going to talk about buying stocks, bonds, REITs, commodities, gold and foreign exchange. But because most of the risk you expose yourself to in investing is due to the Asset Allocation decision, I need to write about it some more. I think you’ll find it worth your while to bear with me a little longer.
Traditionally, investors have built diversified portfolios by buying asset classes like Large Cap Value Stocks, Small Cap Value Stocks, Large Cap Growth Stocks, Small Cap Growth Stocks, Emerging Market Equities, Domestic Bonds, Foreign Bonds, High Yield Bonds, Emerging Market Debt, Real Estate, Treasury Bonds, etc. Don’t worry if you don’t know what all these mean right now, I’ll include a glossary of terms to help out. Just understand for now, these are many of the traditional asset classes people would use to build a diversified portfolio.
Investors would buy as much equity (stocks) as their risk tolerance would allow, and would try to diversify the equity risk with some different bond funds. Their risks would be the volatility of the overall portfolio given its diversified nature and the returns would be the weighted average of the return streams of all the asset classes the investor bought.
I’m going to move away from the discussion for a few paragraphs here. I need to introduce risk, because it is one of the most important tools we use for determining asset allocation. You need to understand how professional investors think of risk. For most of us, when we invest money, we think of our risk as the risk of loss. Investment professionals use a broader definition of risk. They look at risk as the volatility of an asset, or how much the return stream goes up and down during a given time period. Commodities and Foreign Exchange are more volatile than Stocks. Stocks are more volatile than Bonds. Therefore, Commodities and Foreign Exchange have more risk that Stocks, and Stocks have more risk than Bonds.
I’m going to give you one of the most important concepts in investing now. It is critical that you understand this. If you truly understand it you will invest more wisely and won’t be scammed on bogus investments. FOR AN INDIVIDUAL SECURITY, RISK IS DIRECTLY PROPORTIONAL TO RETURN. THE HIGHER THE RETURN STREAM OF A SECURITY, THE HIGHER THE RISK. ALWAYS, NO EXCEPTIONS!
On the same day, an investment that is offered to yield 15% annually is more risky than an investment that is offered at a yield of 10%. The 10% yield is more risky than the 5% yield. Always, no exceptions, if the offer is legitimate. You earn more on an investment by taking more risk. That’s why professionals look at overall volatility and not just risk of loss. They know that investments that can make the most money can also lose the most money.
Getting back to the discussion, another way to think about portfolio construction is to look at it as a compilation of the “Risk Free Rate” plus Beta plus Alpha. The “Risk Free Rate” is how much the government pays on cash instruments (Treasury Bills. The government owns the printing press so it can always print enough money to pay off its debts. That is the only sense that government debt can be considered risk free.) So we can say Return = RFR + Beta + Alpha. Remember that Beta is the excess return coming from the asset classes of your investment, and Alpha is the excess return coming from active decisions you or your manager are making to overweight or underweight securities or different asset classes.
For sophisticated investors only: What has recently become clear, is that for similar levels of risk (volatility) asset classes have very similar returns. Equities appear to have superior returns to bonds only because of the way the market has traditionally packaged them. If you repackage bonds to give them volatility similar to equities, the returns are very similar. This is true for most asset classes. Sophisticated investors can accomplish this repackaging through the use of future contracts or other forms of leverage. This is important, because it allows not only for a diversified portfolio, but for a balanced portfolio as well. Usually, the risk of the equities in a portfolio accounts for the majority of the risk (unless it is also combined with commodities and foreign exchange which is unusual). By repackaging, the risks can be more evenly distributed creating a less volatile, more balanced portfolio. These portfolios will outperform a more traditional structure over time.
For all investors: So, in post-modern portfolio theory, you would construct a portfolio consisting of liquid treasuries (we often call this cash for simplicity), a balanced diversified portfolio of asset classes or Betas, and a diversified portfolio of sources of Alpha. The return on Cash is low, about 3% over long periods of time. It has the lowest volatility and the least risk. The portfolio of Betas, if geared to the risk of equities will have a return over time of 10% to 12%. The returns can vary up and down significantly from that average with a normal range of 7.5% to 14.5%. Good Alpha managers can provide average returns on Alpha of about 1% to 1.5%, but as mentioned above are probably slightly negative on average. Search for Alpha is a zero sum game and there are transaction costs. That means, as a manager I can only get Alpha by taking it away from someone else (my +1% means they have a –1% which leaves zero net gain, then you subtract the transaction cost giving a slightly negative number).
Mixing all of these together in some fashion determines how much risk and how much return you will achieve in your portfolio. The largest pools of investment money are pension plans. They have target returns on their whole portfolio of between 6% and 8%. They have hundreds of investment professionals and the best money managers available. As an individual investor, realistically you should not expect long term returns that are significantly above these numbers. You may have periods of extraordinary returns like happened in the late 1990’s, but these bubbles are followed by the crashes we saw in 2000 and 2001. The outlook for the next cycle is for below average asset returns.
The way many professionals make the asset allocation decision is to back into it from the income stream you need to have in retirement. Let’s say you are making $50,000 per year when you retire. A rule of thumb is that you need 70% of your pre-retirement income to maintain your lifestyle. So you would need $35,000 per year in income. In this example we’ll assume you saved $500,000 in your 401(k). To get $35,000 a year from your $500,000 you would need a return on your portfolio of 7.0% (500,000 x .07 = 35,000). This is realistic. We could take the mix of cash, Betas and Alphas and proportion them to get a mix that returned 7.0% and gave the liquidity needed for emergencies.
However, if I had only saved $200,000 prior to retirement, getting cash flow of $35,000 per year would require a return of 17.5%. This would not be realistic. We could get $12,000 to $16,000 per year from the portfolio and would have to depend on Social Security and part time work to fill the gap. Or we would have to dramatically alter our lifestyle. If we invaded principle to get to our $35,000, the 401(k) would only last 6 years at a 7.0% return.
I’ve ignored the effect of inflation in these examples. You will want your portfolio to increase in size by the rate of inflation each year to keep a constant buying power.
There are some powerful concepts in this section on Asset Allocation.
- Asset Allocation determines how much risk and return you will have from your portfolio
- The higher the return, the higher the risk of an individual security
- The risk of individual securities and be reduced by diversification giving a higher long-term return for the same risk or the same return for lower risk.
- The long-term return for a balanced, diversified portfolio is 6.0% to 8.0% in professionally managed portfolios. A good Alpha manager may add 1.5% to those returns.
- The amount of risk needed in a portfolio can be determined by the cash flow I will need when I retire. Take 70% of your expected income at the time of retirement and divide it by the amount of your savings from all sources. If the result is 10% or less, you have a good probability of being able to build a portfolio that will support you. If it is more than 10%, you need to save more.
- Inflation raises the hurdle you need to cross to achieve your goals.
- Average returns over
long periods of time for traditionally packaged asset classes are:
a. Cash 3%
b. Treasury Bonds 6%
c. Corporate Bonds 7.5%
d. Equities (S&P 500) 11.5% - The portfolio return is the sum of the asset class returns multiplied by the percent of the total portfolio invested in each of the classes e.g. (11.5 x .6) + (6 x .4) = 6.9 + 2.4 = 9.3% for a portfolio of 60% in stocks and 40% in US government Treasury bonds
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Betas (Asset Classes).
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