Asset allocation and selection of investments

Diversification can reduce some of the risks inherent in investing. For example, when the stock of one company in your portfolio declines, other stocks might increase and offset your losses. However, diversification does not reduce market risk. If the stock market declines, the stocks of a diversified portfolio decline also. When the bond and stock markets move together, even a diversified portfolio during down markets is not immune from market risk. Another element that can help to combat market risk is time. When selecting securities with long time horizons, you can wait for stock prices to recover from down markets to sell.

The securities you select depend on your objectives, your circumstances (marital status, age, family, education, income, net worth, and the size of the portfolio), level of risk, expected rate of return, and the economic environment. Asset allocation is the assignment of funds to broad categories of investment assets, such as stocks, bonds, money market securities, options, futures, gold, and real estate. The asset allocation model in Figure 5–2 shows how some of these asset allocation factors determine the selection of investments.

Figure 5-2
Asset Allocation and the Selection of Investments

If, however, you do not tolerate risk as well, a more conservative asset allocation model would be as follows:

Stocks	60%
Bonds	30%
Money market equivalents	10%

An older, retired couple with limited net worth whose objectives are income generation and capital preservation would have a different allocation of their assets. They cannot tolerate much risk, and their time horizon is shorter. To generate regular receipts of income, a greater portion of their investment portfolio would go into fixed-income securities with varying maturities. Generally, the longer the maturities, the greater are the returns, even though risk increases with the length of the maturities. Depending on their circumstances, a small percentage of their portfolio might be allocated to common stocks to provide capital appreciation. A suggested asset allocation model might be set up as follows:

Stocks	15%
Bonds	65%
Money market equivalents	20%

As you can see, the percentage allocated to stocks, bonds, and money market equivalents varies depending on your circumstances and the size of your portfolio.

What works for one investor may not be appropriate for another. For example, the financial characteristics of two investors may be identical, but one investor may need to set aside greater amounts in money market securities to meet ongoing medical bills or some other expected expenditure.

An asset allocation plan should be flexible enough to accommodate changes to fit personal and economic circumstances. For example, when market rates of interest are declining, a greater percentage of the portfolio may be allocated to stocks. Similarly, when interest rates are rising, you could put more of your funds in money market equivalents, and when conditions become more favorable, you can move some money back into stocks (see Table 5–2).

Table 5-2
Guidelines for Asset Allocation
1. Review your objectives and personal financial circumstances. To generate current income and preserve capital, the asset allocation model should be weighted more toward bonds and money market securities. If current income is not needed and you are investing for capital growth in the future, the weighting would be allocated more toward stocks and real assets (real estate, precious metals, and collectibles).
2. Determine your tolerance for risk. If you have a long time horizon and can accept the risks of the stock and real estate markets, a greater amount can be invested in stocks and real estate. If you cannot tolerate risk, the allocation should be weighted more toward bonds and money market securities.
3. Consider the time frame. If you are young and have a long time horizon (about 25 years), allocate a larger percentage to stocks. If you have a short time frame, the allocation would be weighted more toward bonds, with a smaller percentage in stocks.
4. You should not be unrealistic in your expectations of your investments. The returns of the past two decades have been quite spectacular. Long-term bonds in the decade of the 1980s returned, on average, around 13 percent annually. Stock returns were abnormally high during the late 1990s owing to the technology boom and the Internet bubble, only to decline to more realistic levels of valuation in the early 2000s. For example the Standard & Poor’s (S&P) 500 Index earned, on average, around 37 percent in 1995, 22 percent in 1996, and 33 percent in 1997. The decades of the 1980s and 1990s were abnormally good for both the bond and stock markets owing to the decline in interest rates, from around 17 percent in 1980 to the current low of 3 to 5 percent in the early 2000s. You should lower your expected returns to more realistic levels into the future.
5. Consider the risk-return tradeoff in the asset allocation model. How you allocate your assets can affect both risk and returns. For example, according to Ibbotson and Sinquefield (1994), diversification among different classes of investment assets lowered the levels of risk and improved returns. The three portfolios in the study used data during the 1926–1993 time frame. The first portfolio consisted solely of long-term government bonds and had an average annual return of 5.5 percent with a risk (standard deviation) of 11.3 percent. A second, more diversified portfolio consisted of 63 percent Treasury bills, 12 percent long-term government bonds, and 25 percent common stocks of large companies. This portfolio had the same annual returns as the first portfolio, 5.5 percent, but the risk fell to 6.1 percent. A third portfolio consisted of 52 percent stocks of large companies, 14 percent long-term government bonds, and 34 percent Treasury bills. This portfolio returned 8 percent annually with a risk of 11.3 percent. This is the same risk as the first portfolio of bonds, but the returns are much greater.
6. After determining your asset allocation model, the next step is to determine your individual investments. In a speech to the American Association of Individual Investors National Meeting, July 10, 1998, John J. Brennan used the example of a portfolio invested in 100 percent international stocks for the five-year period ending 1990. This portfolio, based on the Morgan Stanley EAFE Index, would have outperformed a portfolio of stocks based on the S&P 500 Index. However, in the five-year period from 1992 to 1997, a 100 percent portfolio of stocks based on the S&P 500 Index would have outperformed this portfolio of foreign stocks. To reduce overall risk, you should divide your stock allocation into different sectors of the economy and then choose the individual stocks for each sector. Foreign stocks should be included. You can do the same for a bond portfolio.

After you’ve determined an asset allocation mix of the broad categories of investments (stocks, bonds, money market funds, and other asset types), your next step is to make your selection of individual investments and amounts to allocate to each. For stocks, it may be useful to review the different categories of common stocks. For example, allocating equal amounts of money to value stocks, growth stocks, foreign stocks, blue-chip stocks, and small-cap stocks reduces the total risk of your stock portfolio. The same process applies to division of the total amount allocated to bonds. The portfolio of individual stocks listed in Figure 5–2 can be classified into sectors and types, as illustrated in Table 5–3.

This table presents a broad representation of the different industry sectors, and most of the companies listed are leaders in their respective sectors. Noticeably absent from this portfolio are small-cap stocks and foreign stocks, which are riskier investments. This portfolio was chosen with the following considerations in mind:

* Large-cap stocks instead of mid- or small caps
* Equal emphasis on growth stocks and value stocks
* U.S. stocks instead of foreign stocks

The easiest way to lose money is to make a few bad investments in stocks and bonds. Nonetheless, many people continue to invest in stocks suggested by friends and associates without even looking at the financial statements of the companies. Rather than relying on a “hot tip” you hear at the hairdresser’s, you should be more scientific about your choice of investments.

Note: This is not a recommendation to buy any of these stocks. Some stocks may be trading at high multiples of earnings owing to increases in price, whereas others may be depressed in a bear market.

You can use fundamental analysis to choose your investments. Using fundamental analysis, you identify industries in the economy that have the potential for doing well. Then you evaluate the companies within those industries for their earnings and growth capacities. Using technical analysis, another method for choosing individual securities, you use past information about prices and volume movements to identify buying and selling opportunities.

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