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Determining The Proper Asset Allocation between, Stocks, Bonds and Cash

Financial Planners and Portfolio Managers are trained to ask investors to define their investment goals. How much return do they want or need? And how much risk can they tolerate.

Many investors find these questions confusing. Almost everyone desires as much return as humanly possible. And while investors don't want risk and volatility, they are generally willing to tolerate it if they are convinced that the high returns will be achieved in the end.

It is well documented and accepted that there is some relationship between risk and reward. Higher returns usually are associated with more risk. However, it is not true that more risk always leads to higher returns. First, if the higher return were guaranteed, then it would not really be risky. Second, financial theory indicates that only efficient risks can be expected to be compensated (on average) by higher  returns. Dumb risks carry no expectation of high returns.

We all want high returns. But because risk tends to go up with higher expected return strategies, we end up being constrained by our capacity to take, and tolerance for, risks. So, Financial Planning involves determining how much risk we can take or want to take and then devising a strategy to maximize return, within that risk constraint.

Our risk constraint then directly impacts how we should allocate funds between stocks, bonds and cash.

Why Invest some Money in Bonds and Cash as well as Stocks?

In simplistic terms, investors have to decide what percentage of their money to invest in each of the broad assets classes. The three broadest asset classes are stocks, bonds and cash (money market). Some analysts like to further sub-divide this and would include other asset classes such as precious metals, real estate and income trusts.

The table below, describes generally the characteristics of the three main asset classes. Note that annual volatility is generally considered to be an excellent measure of risk. This is certainly true to short term investors but is not really true for long-term investors. For long-term investors the bigger risk is long term growth in purchasing power rather than annual volatility.

Determining an Appropriate Asset Allocation

An investor with a very low tolerance for risk (due to a short time horizon or lack of appetite for risk) is virtually forced to allocate close to 100% of their funds to Cash.

Conversely an investor with a very high tolerance for risk (which usually requires both a very long time horizon and a high tolerance for volatility) may choose 100% equities.

Most investors probably fall in between. They may have a relatively long time horizon. But there may be a chance that some life event could cause them to need to liquidate assets unexpectedly. Also most people do not have a very high tolerance for downward volatility and prefer to see a steadier march forward.

A proper determination of the asset allocation is probably best achieved through the services of a competent Financial Planner. Planners can use simulation software that can predict possible future volatility of a portfolio, based on the asset mix chosen and on historic rates of return and volatility be rate class. The software can show not only how the portfolio is expected to grow, but also what can happen in extreme scenarios. Risk and return decisions are not intuitive, most people will make very poor decisions unless they are shown a full range of possible results from simulation software.

Left to their own devices, too many investors (who may need the money in the short term) are probably taking on too much risk by over-allocating to stocks. Investors tend to have  a poor understanding of the likely risks and rewards. We tend to be over-optimistic and we tend to think that stocks are like playing the lottery, except we really don't expect to lose.

Taking a lottery ticket approach is probably okay if we allocate a bit of "fun" money to that game. But investors should not be thinking in terms of winning the lottery when it comes to retirement funds. Rather, we should be thinking of maximizing out expected returns within our risk constraint. That means we first have to define our risk constraint and then understand the best asset mix associated with that risk constraint. The best way to do that is to consult a Financial Planner who has access to simulation software. Investors should insist on seeing simulated results for multiple scenarios, before deciding on their asset allocation.

In the absence of asset allocation modeling software, it may help to examine graphs of actual performance of the three asset classes over various periods of time.

For the investor that has a long time horizon and who is comfortable with the volatility of annual returns and the volatility of potential long term outcomes, a 100% allocation to stocks may be quite acceptable.

Modern Portfolio theory actually teaches that this investor could get the same return with less risk by investing in a optimum combination of stocks and bonds and then borrowing money to dial in more risk and more return. There are several problems with this. First there is no agreement on what constitutes the optimal "market portfolio" allocation of stocks and bonds. Second, most investors are inherently nervous about borrowing for investment. Third, when I attempted to simulate this strategy on actual data over the last 79 years, it did not appear to work. There were some periods where stocks out-performed to such an extent that no amount of leveraging of a portfolio with a significant percentage of bonds, could keep up with the stocks. Over other periods the risk reduction was minimal. I concluded that a highly risk tolerant investor should simply invest in 100% stocks and not attempt to mix in bonds and then boost the return through borrowing and leveraging.

Other Asset Classes

Some other asset classes including precious metals and real estate can potentially offer high returns. In addition these asset classes are not highly correlated with stock and bond returns. Investing a small percentage of assets in these alternative asset classes can substantially reduce risk, while potentially having a small positive or negative impact on overall long-term returns. Again, simulation software is probably the only reasonable way to get a handle on this.

Asset Class Timing and Rebalancing

It would be wonderful to constantly have most of your assets in the best performing asset class each year. But attempting that on a large scale defeats the risk management aspects of having a mixture of asset classes. If an investor believes that they have access to a reliable way to predict which asset classes will out-perform, then it may be worth it to slightly alter the asset allocation in that direction. However, this strategy should be limited to only moderate changes in the asset allocation in order not to destroy the risk management aspect of asset allocation.

Asset rebalancing refers to re-setting the portfolio to the target asset mix periodically. For example if stocks performed best, then some of the winnings from stocks are reallocated to the other asset classes periodically in order to prevent the stock allocation from getting much higher than the target allocation to stocks. This also provides benefits from "dollar cost averaging" since it forces investors to buy the asset class that has moved down in price and sell the class that has moved up the most in price.

Conclusion

In conclusion, consider a visit to a Financial Planner who has proper asset class simulation software. It pays to get this very basic investment decision right before moving on to stock picking. Too many people are diving into stock picking, hoping to "win the lottery", when they have not really stopped to understand the rules of the game and the expected pay-offs.

November 27, 2002 (with minor edits June 17, 2005)

Shawn Allen, CFA, CMA, MBA, P.Eng.

President, InvestorsFriend Inc.

www.investorsfriend.com

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