Asset Allocation: risk reduction realities!

Lets face it, asset allocation models are the heart of financial planning and investment advising. I have highlighted five major lessons we can learn from investment errors and market history in order to get allocations correct!

, Asset Allocation: risk reduction realities!

Mistakes can be made in all kinds of environments. The market’s behavior over the 16-year period from 1987 to 2002 encompasses the extremes, stretching from two severe bear markets with a long bull market in between. This all-encompassing financial market history can provide a number of valuable asset allocation lessons.

Let’s take a look at the performance of several portfolios over this time period. The table presents risk and return measures for five portfolios, which were rebalanced annually, over the period 1987 through 2002. It shows both risk and return measures to more effectively compare the portfolios.

Lesson One: Mixing bonds and stocks moderates portfolio risk.
High-grade bonds and stocks are fundamentally different assets. Bad years for bonds are sometimes good years for stocks and vice versa. During this time period, bonds lost money in three of those years, and in those same years stocks earned money. Conversely, stocks lost money in four of those years, and at the same time, bonds earned money. It is also important to note, though, that 1987 and 1994 were below-average years for both asset classes—that serves as a reminder that both asset classes can have poor years at the same time.

Lesson Two: Portfolio risk rises disproportionately slowly as stocks are added to the portfolio. Over this time period, the risk (as measured by volatility) of a 25% stock portfolio was essentially the same as the risk of the all-bonds portfolio. The additional risk of a 50% stock portfolio compared to an all-bonds portfolio is one-fourth the additional risk of an all-stocks portfolio.

Lesson Three: An all-bonds portfolio is NOT the lowest-risk portfolio. Even risk-averse investors should own some stocks. The maximum annual loss for a 25% stock portfolio was less than the maximum for the all-bonds portfolio. That’s because, when interest rates rise, all bond prices move south.

Lesson Four: Portfolio returns rise disproportionately quickly as stocks are added to the portfolio. Over this time period, the 25% stock portfolio earned about 40% of the additional return on the all-stocks portfolio compared to the all-bonds portfolio. The 50% stock portfolio earned about 75% of the additional return.

Lesson Five: An often overlooked risk for the long-run investor is the risk of having a too-conservative portfolio. By focusing too much on volatility of individual assets instead of the volatility of the entire portfolio, many people often maintain a too-small stock exposure for their long-run horizon. Remember that over this time period, the 25% stock portfolio had a volatility similar to the all-bonds portfolio, but its returns were appreciably higher. And for many investors, the risk-return trade-off favors an even higher exposure to stocks.

So, let’s learn from history and avoid the mistakes of others. Choose an asset allocation that suits your long-term needs based on the amount of risk you think you can withstand, and make sure you rebalance your portfolio every year to maintain a stable risk exposure.