The Asset Allocation Decision

Almost any Professional Financial Planner that you approach will advise you to divide your assets into three major categories or “asset classes”.

These three major asset classes are stocks, bonds and cash.

Stocks represent a share of ownership in a business. Stocks may or may not pay regular dividends.

Bonds represent a loan from yourself to a business. The business pays you a fixed regular interest payment and then repays the loan to you in a lump sum after from 2 to 30 years (or occasionally longer) depending on the maturity of the bond.

Cash includes bank accounts and other guaranteed investments with maturities within one year. You usually receive interest on your money.

It is generally acknowledged and expected that stocks will have the highest long term rate of return but that the return will be quite volatile or risky from year to year and that in fact it will not be at all unusual to suffer a negative return in any given year. Bonds are expected to offer a lower long term return than stocks but with a much reduced volatility (which is considered to be synonymous with risk). Cash investments are expected to have the lowest long term return but your return is known at the time you invest and therefore cash is considered to be essentially risk free (In this case assume that the cash is invested in government guaranteed bank account or securities which have no default risk).

Modern Portfolio theory indicates and most Financial Planners advise that by allocating a proportion of your assets to each of the three classes, and by widely diversifying within the bond and stock categories, you can achieve an optimum balance between risk and return.

In general the youngest investors may be advised to allocate as much as 75% of their assets to stocks while the oldest investors may be advised to allocate no more than 25% of their assets to stocks.

Before You accept any of this advise, I think it is prudent to examine the following questions:

How does inflation affect Returns?

What risk should you be concerned about?

What are the historic returns and volatilities of stocks, bonds and Cash?

Is there a trade-off between risk and return?

If stocks have the highest return should you put 100% into stocks?

When you have these answers then you will be in a better position to allocate your assets between the major asset classes of stocks, bonds, and cash in an intelligent manner.

For answers to these questions refer to Historic Asset Returns for Stocks, Bonds and Bills and Are Stocks Really Riskier Than Bonds? The graphs and information presented in those articles are truly enlightening.