|
|
|
|
Asset Allocation: Prudent Investing Requires It
e review many investment plans in evaluating whether the conduct of an investment adviser was appropriate. With few exceptions, we find that these investment plans, and subsequent actions, have two things in common. First, they all recommend asset allocation among stocks, bonds, and cash. Second, the majority of investment advisers ignore their own or their firm's recommendation.
Asset allocation is fundamental to prudent investing. That means investors need to expose their portfolios not just domestic stocks (small capitalization and large capitalization), but also to international stocks. That means owning bonds (domestic and international), as well as to real estate based and precious metals based investments. That also means keeping some "cash" in U.S. Treasury bills (through money market funds) for short-term needs.
Why bother? Consider the returns. If one believes that domestic stocks outperform everything else, think again! In 2000, bonds (as measured by the Lehman Brothers Aggregate Bond Index) did almost twice as well as large cap stocks (as measured by the S&P 500). In 1990, bonds performed four times better. Likewise, in 1999, international equities (as measured by the MSCI-EAFE Index) performed the best, as they had in 1993 and 1994 as well as 1985 through 1988.
So, why do investment advisers not practice what they preach? There are several reasons (for example, lack of knowledge, laziness, brokerage firm pressure to "push" certain investment products, etc.). One major reason is that these advisers probably are concerned about being perceived as choosing investments that are too stodgy (bonds or cash) or too speculative (real estate and precious metals). As a matter of fact, however, the practice of allocating assets among these asset classes is the best way not only to minimize risk but also to maximize return.
Let's prove that point. First, consider the well-known asset allocation study by Brinson, Hood and Beebower. The authors found that 93.6% of the variance in a portfolio's performance was attributable to the asset allocation selected. By comparison, market timing and security selection played only a minor role, and actually caused lower average returns and increased variability of those returns. Similarly, a study by Schoenfeld, Chen and George showed that, from 1988 to 2000, adding international stocks actually reduced the volatility in a domestic stock portfolio.
Second, a study by Klemkosky and Bharati suggested that an active asset allocation strategy produced higher returns. The key concept is correlation among the asset classes. As well known authority Herbert B. Mayo has written, "If the returns on these assets are not highly correlated with the returns of domestic stocks, the investor may achieve a higher return for the same level of risk … Asset allocation then becomes the determination of that combination of various types of assets that achieves the highest return for a given amount of risk".
What is correlation? It is defined as the statistical measure of the degree to which the movement of two variables is related. The lower the correlation, the more appropriate the allocation. The correlation of the major assets classes (as measured from 1973 to 1994) is set forth below (1.00 is exact correlation):
|
|
|
(1)
|
(2)
|
(3)
|
(4)
|
(5)
|
(6)
|
(7)
|
(8)
|
|
(1)
|
T-Bill
|
1.00
|
|
|
|
|
|
|
|
|
(2)
|
Long Term Corp. Bond
|
.05
|
1.00
|
|
|
|
|
|
|
|
(3)
|
Int’l Bond
|
-.09
|
.35
|
1.00
|
|
|
|
|
|
|
(4)
|
Large Cap Stock
|
-.06
|
.39
|
.12
|
1.00
|
|
|
|
|
|
(5)
|
Small Cap Stock
|
-.08
|
.24
|
.02
|
.79
|
1.00
|
|
|
|
|
(6)
|
Int’l Stock
|
-.09
|
.24
|
.64
|
.48
|
.38
|
1.00
|
|
|
|
(7)
|
Equity REITs
|
-.09
|
.27
|
.13
|
.65
|
.75
|
.41
|
1.00
|
|
|
(8)
|
Precious Metals Mutual Fund
|
-.06
|
-.02
|
.20
|
.21
|
.19
|
.31
|
.16
|
1.00
|
Source: Asset Allocation, Roger Gibson (McGraw Hill, 2000)
As one can see, for example, domestic small cap stocks and domestic large cap stocks have a high degree of correlation. On the other hand, large cap stocks and international bonds have a low degree of correlation. Their low correlation makes them excellent additions to an appropriately asset allocated portfolio.
In conclusion, when prudently structuring a portfolio, asset allocation is required to minimize risk and maximize returns. Your investment adviser should practice what he preaches.
______________________________________________________________________
James J. Eccleston is a securities attorney, representing investors as well as brokers and brokerage firms nationwide in arbitration, litigation and regulatory matters. He is a past co-chair of the Chicago Bar Association's Securities Law Committee, a past chair of its Financial and Investment Services Committee, a registered investment advisor and a licensed securities principal of the National Association of Securities Dealers (NASD). He can be reached at 312-641-2929.
|
|
Sponsored by James J. Eccleston. This Web site contains material of general interest. It is neither intended to, nor constitutes, either legal advice or investment advice.
Always consult an attorney and/or investment adviser when building and protecting your wealth.
All content Copyright © 2010 Advocate Compliance Partners, Inc. except where noted. All rights reserved.
One North Franklin Street, Suite 2620, Chicago, IL 60606
Telephone 312-332-0000 | Fax 312-332-0003
|
|
|
|
