When investors contemplate their long term asset allocation they are more often than not influenced by current market conditions. Unfortunately, that is not how long term, i.e. strategic asset allocation targets should be set. In one of my favorite financial books, The Art Of Asset Allocation the author states “the strategic issues affecting individual investors’ asset allocation decisions include: the timing and magnitude of intergenerational income requirement; the ability to measure, withstand, and be adequately compensated for bearing risk or loss; absolute and relative performance goals and benchmarks for measuring returns; the influence of one or more concentrated investment positions; personal holdings in the form of art, jewelry, or collectibles; and meaningful financial liabilities such as mortgage debt or margin borrowing.”

THE ASSET ALLOCATION PROCESS

The steps that are involved in the asset allocation process, as identified by the author, are as follows: (We have added our own comments in italics.)

1. The investor and advisor examine and then spell out assumptions with regard to future expected returns, risk, and the correlation of future returns between asset classes. Expected returns should be viewed on an intermediate term basis and should be derived from forward looking economic, fundamental, and valuation considerations. Unfortunately, most “models” look backward to determine expected returns. Furthermore, correlations change with time. During the 1982-2000 period stock and long term bond returns were highly correlated. Currently, they are not.
   
   
2. The investor/advisor may select asset classes that best match the investor’s profile and objective and that together provide the maximum expected return for a given level of risk, or stated another way, the minimum risk for a given level of return. In other words, determine what rate of return you need to support future expenditures, and use the minimum risk possible to attain your objective.
   
   
3. The investor/advisor may establish a long-term asset-allocation policy (some refer to this as “Strategic Asset Allocation”), which reflects the optimal long-term standard around which future asset mixes might be expected to vary. The optimal asset allocation will change through time as one gets older or when there is a major change in ones lifestyle.  Importantly, expected long term returns for asset classes may be transformed as industries mature and demographics change. Therefore, the Strategic Asset Allocation should be reviewed at least every five years.
   
   

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   ¹Darst, David. 2003. The Art of Asset Allocation. New York, NY: McGraw Hill
   
   
4. The investor/advisor may decide to implement Tactical Asset Allocation decisions against the broad guidelines of the Strategic Asset Allocation. This is the process by which investment managers can add value by reducing positions at risk in order to preserve capital
   
   
5. The investor/advisor will, in many instances, periodically rebalance the portfolio of assets, with sensitivity to the tax and transaction-cost consequences of such rebalancing, taking account of the Strategic Asset Allocation framework. We do this on an ongoing basis; however, in some cases the tax consequences have to come second.

THE NEW ASSET CLASSES

During the last two years the landscape of available asset types has expanded greatly. Newer exchange traded instruments now allow one to gain exposure to commodities such as oil, natural gas, metals, agricultural products and many international currencies as well. Furthermore, “structured products” which can provide a myriad of truncated-risk equity and bond-like products have become more significant. All of these are considered “alternative investments” as are private equity, hedge funds, and art.

The principle of defining one’s asset choices as stock, bonds, and cash is so passé. Even defining stocks as one asset class is very misleading. For example, utility stocks trade much like bonds while semiconductors do not. Equity risk is really determined by the characteristics of the stocks in a portfolio, or “portfolio composition”. We know the characteristics of your equity portfolio but suspect you don’t. If your investment advisor can generate good equity returns per unit of risk as compared with the appropriate benchmarks and other managers, then you might want to consider a higher equity exposure than you currently have.

Unfortunately, risk and return metrics are the province of passive market portfolios such as the Standard & Poor’s 500 or the Lehman Brothers Aggregate Bond Index. State Street Global Advisors, the developers of the Spider exchange traded funds, has shared their expectations for many of these passive (unmanaged) indexes at a recent meeting. The results are shown in the table on the following page.  If there is one thing certain on this earth besides death and taxes, it is that these forecast returns will bear no resemblance to reality; however, their measure of risk (standard deviation) may well be fairly close. The standard deviation is a key measure of the dispersion, variability, or volatility of a data series around its mean. “Simply stated, standard deviation gauges the probability of a return being near the expected mean.” By mixing assets types within a portfolio, one can dramatically change the standard deviation so that the return per unit of risk far surpasses that of cash-equivalents. This is particularly true of asset types whose returns are not correlated with one another. As an example, over the last five years ending June, 2007 Dolan Capital Management’s balanced portfolio sample (approximately 65% equity and 35% bonds) has returned 8.84% annually but produced a standard deviation of only 3.73%. (This time frame includes the last half of the bear market during 2002-2003.) As you compare this to the standard deviations in the following table, this measure of risk is quite low.

Long-term Asset Class Forecasts
For Common Asset Classes Over Multiple Time Horizons

(*) Standard deviation of quarterly returns over a five year period.

(1) Europe, Australia & Far East   (2) Lehman Bros. Aggregate (3) Treasury Inflation Protected Securities (4) Market Neutral

In a commentary entitled “Gentlemen Prefer Bonds” in 2003 we provided a return and risk table of different maturity Treasury bonds and the S&P 500. Over the measurement period (1988-2002) these investments provided modestly differentiated returns but significantly diverse levels of volatility risk. In the table below please observe that not all bonds are without volatility and some can be more volatile than the stock market. It is really in the arena of relatively shorter term maturing bonds that variability risk is reduced to such a low level so as to have a significant impact on an entire portfolio and offer the certainty of return that many desire.

            Treasury Bonds: Return & Risk    1988-2002                

CONCLUSIONS

The best combination of risk and return is easy to define: high return and low risk. It’s not so easy to define which asset allocation is best to achieve that. When considering your asset allocation remember that portfolio composition both from a stock and bond perspective does not guarantee you the type of risk-adjusted return that you might have envisioned and that we need to understand your return objective first.

Which condition can you best cope with . . . interim volatility or not achieving your financial objectives? For example, let’s assume that your portfolio is invested 40% in bonds in order to reduce risk and over the intervening years the rate of inflation increases. If you have invested in long-term bonds (to achieve a higher yield) the portfolio will loose absolute value over much of its lifetime until the bond reaches maturity.  Moreover the bond will loose purchasing power because it is a fixed-income instrument (that is to say, its coupon is fixed). On the other hand, a stock whose earnings might benefit from modest inflation would sustain purchasing power. That is why return objectives should be stated in inflation adjusted terms and why asset allocation decisions are in large part determined by the rate of change of inflation.

In our opinion the best asset allocation for achieving one’s real return objective is to implement a strategy which allows your investment advisor to be flexible in his or her choice of asset types.  On the other hand, the best asset allocation for containing volatility risk is one that caps the average maturity of the bond portfolio at around five years. Clearly, as one gets close to retirement, and especially after retirement, containing volatility risk becomes important because you are making periodic withdrawals. Just how does asset allocation impact retirement planning? In the table below we show our estimates of spend-down years (i.e. before the assets are exhausted) under differing circumstances. For example let’s assume you estimate you could retire on $70,000 per year and your portfolio was worth $1,000,000 and was capped at a 40% stock allocation. Your portfolio would last for 19 years. If you could live on $50,000 per year, you would add another 12 years to the life of your portfolio. However, if your asset allocation was capped at a 60% stock allocation, the portfolio would exist for 36 years!

            WITHDRAWAL RATES & MAXIMUM YEARS OF DRAW DOWN*

Needless to say, Strategic Asset Allocation is not an easy puzzle to solve. Analyze the State Street long term return objectives and match those with the kind of return you need. Then review the table above to ascertain the retirement income you’ll need. Consider changing your strategic asset allocation or revert to a flexible plan which allows us to achieve your required rate of return.