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Asset allocation: Don't lose sight of the
time horizon
Heydon Traub, Boston Business
Journal, March 28, 2003
When they think about investments, many people focus mostly on issues like
picking stocks, picking bonds or selecting funds that invest in either or
both of these assets. The reality is that even over a period as short as,
say, five years, most general stock funds will have similar returns, and
most bond funds will have very similar returns.
Far more important for investors is to make the right asset allocation.
A well-developed plan for one's asset allocation will promote adherence to
long-term objectives, provide a disciplined process and serve as a guide
through difficult markets, such as the one we face today. A key
consideration is a person's goals and objectives. For the purpose of this
discussion, we will assume the primary goal of investing one's savings is to
provide funds for retirement.
A review of spending requirements is key to developing the return
requirements. Estimating retirement spending requirements will help
determine the minimum rate of return for the portfolio. A good way to think
about returns is how much "real" return you need, with "real" being the
return over inflation. For example, a 5 percent real return target and an
assumed inflation rate of 3 percent would mean a required return of 8
percent.
The offset to return is to identify an acceptable level of risk that can be
taken in the portfolio. This includes the traditional volatility review as
measured by standard deviation. Standard deviation is a measure of the
fluctuation of returns over time.
However, standard deviation is not the only measure to be considered. Other
risks are the ability to handle both near- and long-term losses,
consideration of a maximum acceptable loss for a given period of time and
the implications if the required return is not met. The time horizon that
the assets will be invested will help in the risk analysis. Investment risk
decreases over time, which implies that longer time horizon portfolios can
invest more in stocks than those with short horizons.
The cornerstone of a good allocation is diversification across asset
classes. Utilization of core asset classes — such as large-cap equity,
small-cap equity, international equity and fixed income — is a starting
point for the analysis. Additional asset classes such as emerging markets,
high-yield bonds, real estate, hedge funds, etc., should also be considered
depending on the comfort level and appropriateness for the investor. Owning
a broad range of asset classes will reduce the overall level of risk in the
portfolio and creates a more optimal portfolio over time.
Style diversification is also important. To protect against being
concentrated in one style at the wrong time (as many investors were over the
last few years via their growth funds), allocations should include
representation from both value and growth styles within each significant
equity asset class.
The reason diversification is so critical is that not all assets move
together in terms of return. In the last few years, while stocks have been
tanking, bond returns have been quite positive. To show a simple example
with real data, we took a look at the returns of the stock market (S&P 500)
and high quality U.S. bonds (the Lehman Brothers Aggregate Index). Over the
10 years ending 2002, stocks had annualized returns of 9.3 percent while
bonds returned 7.5 percent. The volatility (risk) of stocks was 17 percent,
while for bonds it was just 4 percent. Stocks have provided a wild ride, but
over the whole period did better than bonds.
Now if you had a 50/50 mix of the two, your return would be the average of
the two, or 8.4 percent. However, because they don't move up and down
together, the risk is not the average of 17 percent and 4 percent (which
would be 10.5 percent), but instead its risk is just 8.9 percent.
This is why it probably makes sense, even for aggressive investors, to have
at least 10 percent to 20 percent in bonds. As the return over several years
or more likely drops minimally, but the risk will likely come down pretty
significantly.
Thus, for investors with long horizons (say, 20 years to retirement) and who
can stomach taking risk, something like 80 percent in stocks and 20 percent
in bonds may be a good mix. For investors with short horizons (say less than
three years to retirement) and/or those who are quite risk averse, a mix of,
say, 20 percent in stocks and 80 percent in bonds is more appropriate. Those
who fall in between in terms of horizon and risk should adjust accordingly,
but being at 50 percent in each probably won't be too far from ideal.
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