Chapter 1_What is Asset Allocation

Chapter 1 What is Asset Allocation?

Chapter 1

What is Asset Allocation?

As explained in the Introduction, asset allocation is defined as the process of dividing investments

among different kinds of asset categories. This process is done as part of a larger plan or strategic

asset allocation. Strategic asset allocation involves the decision making process in order to

determine the asset allocation mix, time horizon, and objectives associated with an investment

plan. Once this process includes, periodic review takes place to rebalance allocation percentages

in order to ensure the plan is proceeding as intended. This approach to asset allocation and

investment planning is a passive one that does not necessarily produce wild returns in a raging bull

market but more often than not, it protects an investors downside when the market experiences

prolonged periods of economic downturns.

In 1986, economist Gary P. Brinson, along with his colleagues L. Randolph Hood and Gilbert L.

Beebower released a landmark 10-year study of investment performance for 91 pension funds

managed by SEI Investments. Entitled, Determinants of Portfolio Performance and appearing in

the July/August 1986 issue of the Financial Analysts Journal, the study sought to answer the

following questions concerning the factors that determine the performance of an investment fund:

(1) How much of an investment portfolios return is attributable to investment policy; (2) How

much of a portfolios return is attributable to differing investment policies; and, (3) How much of

a portfolios return is tied to its benchmark index. Figure 1 illustrates the variability of returns as

shown by Brinson.

Figure 1: Variability of Returns Mutual Funds (Active) vs. Pension Funds (Passive)


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Figure 1 illustrates the variability of returns between funds on the lower end of the scale or 5th

percentile of a time-series regression scale (the far left hand side of the y axis) and those in the

95th percentile (represented on the right hand side), comparing mutual funds, which are actively

managed, and pension funds which are not as actively managed. The results show a wider disparity

for mutual funds between the 5th percentile and 95th percentile than pension funds. This further

shows that adherence to an investment policy, based on asset allocation, has the greater influence

on investment returns over market timing or securities selection.

Brinson et. al. looked at the effects an investment funds policy, the period in which an investment

is made, and the selection of individuals securities, had on a portfolios total return. In further

consideration of the range of returns between the percentiles, according to the Brinson study the

variability of returns between the 5th percentile or poorer performing funds and the 95th percentile

or top-tier performing funds ranged from 46.9 percent to 94.1 percent for mutual funds and 66.2

percent to 97.2 percent for pension funds. The tighter range for pension funds can be attributable

to a greater adherance to investment policy in terms of strategic asset allocation than with mutual

funds, which are more actively managed and have a higher turnover ratio.

Table 1: Comparison of Investment Returns (Policy versus Strategy), 1974 1983

Average Return Standard Deviation

Policy 10.11% 0.22%

Policy and Timing 9.44 0.52

Policy and Selection 9.75 1.33

Actual Portfolio Returns 9.01 1.43

Investment policy is the biggest determinant with respect to an investments return. The

information provided in Table 1 more than suggests that a reliance on establishing an investment

plan based on long term investment goals, objectives, and risk tolerance produces better returns

than a portfolio based on both investment policy and market timing, investment policy and security

selection or the portfolios actual returns.

In Figure 2 (as well as in Table 1), there is little variance from the average return for a portfolio

based on investment policy (0.22 percent) as oppose to a variance from the average of 1.43 percent

for the portfolios actual returns.

The investment returns based on investment policy were 0.67 percent higher than those returns

based on both investment policy and market timing; policy returns were 0.36 percent above those

based on policy and investment selection; and, investment policy returns were 1.10 percent more

than those based on the portfolios actual return (Table 1 and Figure 2).


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Figure 2: 10-Year Average Annual Investment Returns, 1974 1983

Understanding the determinants that drive investment return is a key part of understanding the

importance of asset allocation and how it is employed to shape an investors portfolio. It is well

established that the thought and effort that goes into determining an individuals investment policy

weighs heavily in the overall results of their investment return.

Determining Asset Mix

Part of the consideration that goes into employing asset allocation is the selection of securities to

be placed in the plan. The Chapter 3 and the Index to this book provide a list of different asset

allocation portfolios based on varying mixes of asset classes (as discussed further in this chapter).

The type of investor that you are and your aversion to risk will dictate the mix of assets within

your investment portfolio.

It is important to understand the historical returns of various asset classes (i.e. cash, bonds, and

stock), in order to properly determine the appropriate asset mix. Knowing the returns of differing

asset classes will help to bring more clarity to the risk pyramid, which appeared in the Introduction

section.

Average Return

Standard Deviation


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Investment Returns by Asset Class

As has been discussed, there are different rates of return for different levels of risk. This is the risk-

reward trade off discussed in the introduction. As we move up the investment pyramid, we find a

higher expected return for options, derivatives, real estate and other alternative investments over

stocks, bonds, and cash and cash equivalents.

The basis for this trade-off can be found in the historic returns of the major asset class categories,

cash, bonds, and stock. As you can see demonstrated in the risk-reward pyramid, there is a direct

relationship between risk and reward. If you are wiling to stomach the inherent volatility associated

with investing in the stock market, you should be rewarded with a higher investment return than if

you put your money in a relative risk-less investment such as cash and cash equivalents such as

3-month U.S. Treasury bills.

Inflation

To evaluate the importance of asset allocation, it is helpful to take a look at the difference returns

for different asset classes versus inflation. We begin by looking at the rate of inflation for the 25-

year period between 1983 through 2007. The rate of inflation is based on the Consumer Price Index

(CPI) for urban consumers, which is a fairly accurate measure of rises in consumer prices (Table

3).

Table 3: Historical Rate of Inflation, 1983 2008

Year CPI-U Year CPI-U

1983 3.2% 1996 3.0

1984 4.3 1997 2.3

1985 3.6 1998 1.6

1986 1.9 1999 2.2

1987 3.6 2000 3.4

1988 4.1 2001 2.8

1989 4.8 2002 1.6

1990 5.4 2003 2.3

1991 4.2 2004 2.7

1992 3.0 2005 3.4

1993 3.0 2006 3.2

1994 2.6 2007 2.8

1995 2.8 2008 3.8

Retrieved from http://www.usinflationcalculator.com/inflation/historical-inflation-rates/


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CPI is an important measure to gauge investment results. Investments that fail to produce an

investment return that is at least as high as the prevailing inflation rate loses to purchasing power.

The concept is an easy one to grasp: imagine that you loan $1,000 to a friend today and they offer

to options to pay the money back. In the first option, the friend offers to pay the $1,000 back to

you in five years, at five percent interest per year. Option 2, the friend pays you back $1,000 at the

end of the year. Which would you prefer?

Although you may be inclined to take the money at the end of a year (as most people would), the

better option is to take the money five years from now. Waiting five years will give you a total

amount of $1,276.28. Assuming that the historic annual rate of inflation is 3.41 percent, the value

of $1,000 in 5 years is eroded to $845.64. The value of $1,000 in five years at 3.41 percent

appreciates to $1,182.53. If your friend only paid you $1,000 in five years, you would lose $336.89

in purchasing power due to inflation. Conversely, if your friend pays you a compound interest of

five percent, you would be ahead of inflation by $93.75.

Investments that earn less than inflation are more susceptible to inflation or purchasing power risk.

This is why we seek investing alternatives that allow our money to grow at a pace that is at least

as high if not higher than inflation. Different asset classes clearly have different rates of return.

Our goal is to minimize the risks associated with investing and maximize our return, adjusted for

inflation (and taxes, although for the moment, we will leave that discussion to the side). To do that,

we want to adopt a process of allocating assets accordingly among different asset classes in order

to accomplish this goal.

Asset allocation helps us achieve our investing goals in that it takes advantage of the variability of

returns as we set policy for investing and clarifies what we seek to accomplish. This becomes more

evident as we see the different historical returns and cash, bonds, and stock and carry this theme

into Chapter 3 when looking at the Modern Portfolio Theory and other determinants that go into

establishing investment policy.

Cash

Cash is deemed the safest place for your money, when held in a money market instrument such as

U.S. Treaury bills, certificates of deposit, repurchase agreements and commercial paper. For the

average investor, access to the money market comes by way of money market funds, U.S. Treasury

bills and Treasury Inflation Protection Securities (TIPS).

A money market fund is one specifically designed to provide a stable vaue of $1. The problem

however is that while your money sits in a money market funds, it loses to the opportunity cost of

investing it in some other instrument with a greater potential for gain. Your biggest risk in a money

market fund is inflation risk. This can be combatted by going directly into U.S. Treasury bills


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Table 4: Historical Investment Returns Cash*, 1983 2008

Year Yield Year Yield

1983 8.62% 1996 5.01%

1984 9.54 1997 5.06

1985 7.47 1998 4.78

1986 5.97 1999 4.64

1987 5.78 2000 5.82

1988 6.67 2001 3.40

1989 8.11 2002 1.61

1990 7.50 2003 1.01

1991 5.38 2004 1.37

1992 3.43 2005 3.15

1993 3.00 2006 4.73

1994 4.25 2007 4.36

1995 5.49 2008 1.37

Retrieved from http://www.federalreserve.gov/datadownload/Build.aspx?rel=H15

*Based on the annualized secondary market discount rate on the 3-month U.S. Treasury Bill

We can measure investment returns on money market funds by looking at the investment yields

on the 3-month U.S. Treasury bill trading in the secondary market (for the sake of establishing

concepts, we will defer a discussion on markets and investment principles for later in this book).

Based on the annual yields published by the Federal Reserve for the 25-year measuring period

(Table 4), you can see that money market funds have outpaced inflation, except for the period

between 2002 2005, which may be attributable to the effects of the Iraqi War.

One myth that should be debunked is that of a riskless investment. It is thought that since cash

and casj equivalents, such as money market funds, closely mirror or outpace inflation, this asset

class represents a riskless investment. Although there is credence to the argument that you are not

subject to the same types of risks associated with investing in other asset classes, you are still

subject to purchasing power risk, as evidenced in the 4-year period between 2002 and 2005.


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Bonds

Table 5: Historical Investment Returns Bonds*, 1983 2008

Year Yield Year Yield

1983 11.18% 1996 6.71%

1984 12.41 1997 6.61

1985 10.79 1998 5.58

1986 7.78 1999 5.87

1987 8.59 2000 5.94

1988 8.96 2001 5.49

1989 8.45 2002 5.43

1990 8.61 2003 4.96

1991 8.14 2004 5.04

1992 7.67 2005 4.64

1993 6.59 2006 4.91

1994 7.37 2007 4.84

1995 6.88 2008 4.28

Retrieved from http://www.federalreserve.gov/datadownload/Build.aspx?rel=H15

*Based on the annualized market yield on the 30-year U.S. Treasury Bond. Note that the 30-year bond was discontinued on February 18, 2002 and

reintroduced February 9, 2006. The 20-year U.S. Treasury Bond yields were adjusted for that period to reflect the nominal yield on the 30-year

bond for the period (www.treas.gov/offices/domestic-finance/debt-management/interest-rate/ltcompositeindex_historical.shtml).

Bonds provide a higher investment yield than cash. The investment yields on bonds are measured

by the nominal rate offered on the 30-year U.S. Treasury bond. Given the long-term nature of these

rates they tend to be indicative of overall rates for all fixed income securities. Table 5 provides the

published yields for the period 19832008.


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Stocks

Table 6: Historical Investment Returns Stocks*, 1983 2008

Year Return Year Return

1983 22.56% 1996 22.96%

1984 6.27 1997 33.36

1985 31.73 1998 28.58

1986 18.67 1999 21.04

1987 5.25 2000 -9.11

1988 16.61 2001 -11.89

1989 31.69 2002 -22.10

1990 -3.11 2003 28.68

1991 30.47 2004 10.88

1992 7.62 2005 4.91

1993 10.08 2006 15.79

1994 1.32 2007 5.49

1995 37.58 2008 -37.00

Retrieved from http://1.bp.blogspot.com/_C0Jf4qaV4-8/SYQO9ftlppI/AAAAAAAAAH0/oCx7z3stdkg/s1600-h/1980-

2008_stock_market_returns.JPG

*Based on the Standard & Poors (S&P) 500 Composite Index

Stocks represent the highest level of return, relative to risk. There are many factors that go into a

stocks investment return that can be segmented by company, industry, market sector, region,

country, and other variables. Because these factors represent both systematic and non-systematic

risks, you can stand to lose as much, if not more, than what you stand to gain investing in stocks.

Table 6 represents the returns for the Standard and Poors (S&P) 500 index for the 25-year period.

We chose the S&P 500 index because it is often cited as the best predictor of market movement.

We could have just as easily chosen the Russell 2000 or Wilshire 5000 indices, which are broader

based measures of the stock market but the accuracy of the S&P 500 as a benchmark is suitable

for comparative purposes in this book.

What you see in Table 6 that differs from the rate of inflation and returns shown for cash and bonds

for the same period is the introduction of negative results. The greater potential investment returns

that you seek, the greater the risk you should be willing to take.


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Figure 3: Comparison of Asset Class Returns versus Inflation, 1983 2007

Figure 3 shows that the variability in returns for equities such as stocks is far greater than it is for

other asset classes and that there are far greater external influences that affect the way in which

stocks move than cash and bonds. This is important to know because for the purpose of investing,

stocks give you the greatest potential return on your investment in the asset class, but also expose

you to the greatest amount of volatility or risk of loss.

Over the long-term we know that stocks (and specifically the sub-asset class small-cap stocks)

return a much higher annual rate of return than either cash or bonds. According to the Ibbotson

Associates yearbook figures for rates of return by asset class, the annual average rate of return for

small-cap stocks is 17.5 percent, followed by large-cap stocks at 12.4 percent. Bonds came in at

around 5.5 to 6 percent and inflation was 3.1 percent (Figure 4).


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Figure 4: Historic Rates of Returns (Compound Annual Rates of Return 1926-2003)

Inflation (CPI-U) 3.1%

Intermediate-Term Government Bonds 5.6%

Long-Term Government Bonds 5.8%

Long-Term Corporate Bonds 6.2%

Large-Cap Stocks 12.4%

Small-Cap Stocks 17.5%

Source: 2004 Ibbotson Associates, Inc. All rights reserved. Certain portions of this work were derived from copyrighted works of Roger G. Ibbotson and Rex Sinquefield.

We can further compare the historic returns for various asset classes. Ibbotson Associates, Inc.,

which is a wholly owned subsidiary of Morningstar, Inc., publishes an annual yearbook on

investing and different investment asset classes entitled Stocks, Bonds, Bills, and Inflation

Yearbook. In the 2004 yearbook, the historic returns for the 70+ period between 19262003 closely


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mirrored the asset class returns vis--vis inflation that are illustrated in Figure 3 (Table 7 and Figure

5).

Table 7: Historical Investment Returns By Asset Class, 1970 2004

Asset Class Compound Annual Return Standard Deviation

Commodities 12.38% 19.88%

U.S. Stocks 11.22 17.23

International Stocks 11.09 22.45

International Bonds 8.76 8.83

U.S. Treasury Bonds 8.74 7.05

Treasury Inflation Protection Securities (TIPS) 8.25 11.74

U.S. Treasury Bills 6.27 3.00

Inflation (CPI) 4.74 3.18

Source: 2006 Ibbotson Associates, Inc. All rights reserved.

Figure 5: Historical Investment Returns By Asset Class, 1970-2004



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How Asset Allocation Influences Investment Results

Reducing Risk and Maximizing Profits

Asset allocation works in helping balancing the differences in asset classes, in order to produce a

return that respects the risk profile of the investor. This balancing of risk produces a relative rate

of return for a given level of risk that the investor is willing to accept (this is discussed more in

Chapter 2).

There are 2 broad categories of risks that affect securities and investments, systematic and non-

systematic risks. Systematic risk affects all securities across within an asset classes, sub-classes

and sector without regard to a specific issue or security. It is also referred to as market or un-

diversifiable risk. Non-systematic risks, which are referred to as specific or diversifiable risk,

affects a particular security.

The different types of systematic risks include:

Interest-rate risk the risk that the value of securities will drop because of a drop in the

underlying rate of interest. When interest rates rise, the prices on bonds when issued are low

but interest rates are higher than those on similar bonds that were issued previously. This is

done as a way to encourage new bondholders to invest in the issue but has an adverse affect on

existing bondholders since the value of their bonds fall. This risk not only affects fixed-income

securities such as bond but also affects utility stocks and preferred stock issued by a corporation

since both types of securities are most affected by changes in interest rates.

Inflation risk the risk that the value of your money dollars is eroded by the general rise

in prices for goods and services. Also referred to as purchasing power risk, inflation risk

requires you to earn an investment return that is at least as high as the rate of inflation The

current annual long-term rate of inflation, as measured by the consumer price index, since 1912

is 3.41 percent, according to the Bureau of Labor Statistics. An investment earning less than 4

percent has a lower purchasing power since its return has not out-paced inflation.

Currency risk this risk affects the value of currency, arising when a change in value occurs

between different currencies. For example, lets say that a business is operated that trades

internationally where the business owner is paid in U.S. currencies based on prevailing Euro

exchange rates. The concern of the business is the strength of the U.S. dollar falls against the

Euro. A contract that pays me 2.5 million Euro where the dollar is at 80 cents to the Euro

would be denominated in U.S. dollars at $2 million USD. If at the inception of the contract

U.S. dollars and the Euro were at par with each other, $500,000 was lost due to currency risk.


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Liquidity risk the risk that a security may not have a ready market for me to sell, causing me

to lose to opportunity cost. Liquidity risk occurs when you have a security to sell but no buyer

to match up with. Companies that are closely held, start-ups, and have small market

capitalization are more susceptible to liquidity risk. This risk effects all securities such as

stocks and bonds.

Political risk the possibility that political unrest or a change in the government of another

country that you invest in will cause the value of your investment to become worthless. Such

events as war, terrorist attacks, regime change and other political unrest may cause a new

government to cease financial assets invested in the country or a deposed leader to plunder his

or her countrys national treasury, causing the value of any securities issued to plummet.

Political unrest can also affect the value of securities issued by foreign companies doing

business in a country with political unrest.

Where systematic risks cannot be diversified and impact the entire market, non-systemic risks are

specific risk that is particular to an asset class, sub-class or sector. Non-systematic risk includes

the following types of risks:

Management risk management decisions and other actions of a company that can have an

impact on the companys stock or other securities issues and cause an investor to lose value.

For example, it was disclosed in late 2008 that many U.S. banks were heavily leveraged in

what were termed toxic assets, which were bets on repackaged subprime mortgages. These

instruments, known as credit default swaps and credit default obligations were a highly

complex securitized form of debt that paid high interest rates based on the poor credit ratings

of borrower who took out the underlying loans. As these home mortgage defaults began to rise,

many of these hybrid securities blew up, causing the balance sheet of many banks to take a big

hit, precipitating one of the worse financial crisis in this country since the Great Stock Market

crash of 1929.

Credit risk is a risk that affects the creditworthiness of a bond issuer. The investors chief

concern is that the bond issuer will be unable to meet their obligation to make regular interest

payments due this may be due to some financial difficulty that the issuer is experiencing.

The different systematic and non-systematic risks are summarized in Table 8.


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Table 8: Systematic and Non-Systematic Risks

Systematic Risks (Market Risks; Un-Diversifiable Risks)

Interest-Rate Risk Changes in prevailing interest rates affect the value

of your investment

Inflation Risk (Purchasing Power Risk) Also known as Purchasing Power risk; affects the

buying power of your investment

Currency Risk Compares the value of 2 currencies and how

changes in 1 impacts the other

Liquidity Risk The risk that a market is unavailable to sell a

security

Political Risk Changes in regulations or political unrest and their

impact on the value of your investment

Non-Systematic Risks (Specific Risks; Diversifiable Risks)

Management Risk Decisions made by the management of a particular

company and its impact on the value of the

companys securities

Credit Risk (Default Risk) A fear that the creditworthiness of a company or

other issuer may fall and render the investment

worthless

Reinvestment Risk An inability to replace a security that has been

called by the issuer with another of comparable

value

There is more on risks provided by the Financial Industry Regulatory Association, Inc. (FINRA)

in Appendix 2. FINRA is the merger of the NASDR, Inc. and New York Stock Exchange

regulatory arm in 2008. The information provides a good primer on managing risks and introduces

much of the discussion we have had here regarding the inherent tension that exists between risk

and return among different asset classes.


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Chapter Summary

We began this chapter with a look at what asset allocation is, looking at the work conducted by

Gary Brinson et.al. and Roger Ibbotson. Brinson and Ibbotson showed that the variability or

changes in investment returns was due more to the investment policy established by the investor,

more than timing the market or the selection of assets within the portfolio or fund. Understanding

the importance that investment policy plays in determining how to create an investment portfolio

leads to the process of asset allocation.

Determining the assets mix that is appropriate begins with taking a look at the historic returns for

various asset classes, including inflation. We use inflation as a base line for all investment returns

since the purchasing power of money is eroded over time due to inflation risk. Looking at the rate

of inflation, as measured by the consumer price index, against benchmark measures for cash (3-

month U.S. Treasury Bill), bonds (30-year U.S. Treasury Bond), and stocks (Standard and Poors

500 Index) for the period 1926-2003 we see the following annualized returns:

Asset Class Benchmark Measure Historic Return

Inflation Consumer Price Index (CPI-U) 3.1%

Cash 3-month U.S. Treasury Bill 4.0%

Bonds 30-year U.S. Treasury Bond 5.8%

Stocks S&P 500 12.4%


Asset allocation strikes a balance between returns and volatility, which is the risk of loss. In

striking this balance, an investor needs to consider the impact different types of risks have on the

investment returns that they receive. Risks can be classified in 1 of 2 ways, as being systematic

risks and non-systematic risks. Systematic risks, also known as market risks, are those risks that

affect all asset classes regardless of type. Systematic risks include inflation risk, interest-rate risk,

and political risk. Systematic risks cannot be reduced through diversification.

Non-systematic risks are those that are specific to a security or particular investment. Known as

specific risks, non-systematic risks include management risk and credit or default risk. Non-

systematic risks can be dealt with by varying the percentage of holdings in any one type of security

or asset class (including sub-asset class as listed in Appendix 3).

Documents

Chapter 1_What is Asset Allocation