More on Higher Order Asset Allocation

Consider the 60/40 – stock/bond asset allocation (AA) plan of my comments from March 6, 2009, “Fundamental Asset Class Definitions and Asset Allocation. First, it is important to understand that a simple 60/40 asset allocation plan is a very good plan that is very easy to implement. Historically, it will beat the performance of most other investors provided you use low fee investment instruments to construct the portfolio (ie low cost index funds or Exchange Traded Funds) and you consider a time frame of about a decade or more. Many investors would like to improve on the simple two asset class allocation by including a more sophisticated allocation analysis. There is no guarantee that consideration of additional asset classes will improve performance, so there is no optimum way to construct a more sophisticated asset allocation plan. But historical analysis can help to produce plans that would have performed better under certain economic conditions in the past. What follows are two examples of how to develop a more complex asset allocation plan.

An investor might start by observing that many broad stock market indexes are overweighted with large-cap and underweighted with small-cap stocks. That means that large companies are over-represented in the index as compared to smaller companies. By splitting the stock allocation in half, a second order allocation plan with three components is achieved. The new allocation includes 30% large cap stock, 30% small-cap index, and 40% bond. Introduction of small cap stocks in the allocation historically provides greater long-term returns but also introduces greater volatility (based on 130 years of US stock market history). If an investor is nervous and does not feel comfortable with increased volatility, the second order AA plan would not be advised. If the investor is more experienced and able to maintain the plan through small-cap downturns that may last several years, the second order plan is likely to result in greater long-term returns. Notice that additional appropriate funds must be identified and purchased for this more complex asset allocation plan. In fact, with each addition of a new asset class, additional funds must be used.

Another AA alternative would be to partially replace the small-cap fund with a Real Estate Investment Trust (REIT) investment. REIT returns have been weakly correlated to large cap stock returns in recent years, but tend to exhibit less volatility than small-cap funds during most periods of time.

Further sophistication of the allocation plan can be added by differentiating between value and growth funds. Both the large-cap and small-cap portions of the stock investment can be further split to include large-cap value and small-cap value funds to complement the general large-cap fund and general small-cap fund. The additional weighting of value stocks in the stock portion of the portfolio has historically both decreased volatility and increased long-term return (although not in every historical period). The resulting third order allocation plan includes as many as six components: 15% general large-cap stock, 15% large-cap value fund, 10% general small-cap stock, 10% small-cap value fund, 10% REIT, and 40% short-term bond.

Starting again with a first order 60/40 – stock/bond AA, an alternative asset allocation example can be developed. An investor might decide to split the general stock allocation into large-cap domestic stock, international stock, and small-cap domestic. Over some periods, international stocks have shown low correlation to US-based stocks. The inclusion of 15% to 25% international stock in a portfolio has helped produce both greater returns and reduced volatility during these periods. A second order asset allocation plan designed to address this might include 20% large-cap domestic stock, 20% international stock, 20% small-cap stock, 20% short-term bonds, and 20% intermediate term bonds. In this example, the bond asset allocation has also been sub-divided to provide stability over shorter periods of time.

Both of the above second order asset allocation plans can be rationalized and neither can be proven to be “optimal” for the future. Still other plans can be developed based on examination of alternative subdivisions of the general stock/bond asset classes and historical correlation and volatility data. Before subdividing the general stock/bond allocations and adding an asset class, you should understand what that asset is, the cost of owning it (fees), the risk it brings to your portfolio, and how it may correlate with the other assets in your plan. Adding asset classes without this basic understanding can hurt rather than help your investment portfolio. The number of assets in an investment plan is not an indication of sophistication. If you don’t understand an investment, don’t buy it. An investor that maintains the simple first order stock/bond allocation has historically outperformed most other investors. This is often done with as few as two market-tracking index funds. The simple stock/bond allocation plan, when coupled with a reasonable spending model and regular saving, will get you to a comfortable retirement.

More on Asset classes and Investment Options: http://www.golio.net/Chapter5.html

More on Asset Allocation (see Section 6.2): http://www.golio.net/Chapter6.html

Some material is from Golio, Engineering Your Retirement, Wiley, 2006. (see http://www.golio.net/)

Fundamental Asset Class Definitions and Asset Allocation

Asset allocation (AA) focuses on managing investment risk while accepting that an investor is not likely to be able to predict what will happen next in the markets. An asset allocation plan involves choosing the asset classes that will comprise the plan and setting target percentages of the overall portfolio that should be invested in each class. Studies show that the asset class choices for an investor are the primary indicator of both performance and risk when considered over long periods of time. The actual specific investments within those asset classes are far less important. An AA plan requires periodically (typically once per year) rebalancing the portfolio as one asset class outperforms another. Rebalancing maintains the portfolio risk at a fairly constant level.

What is an asset class? The most fundamental distinction of asset classes is stocks vs. bonds.

A bond is a loan for which the investor is the lender. They are like IOUs. When a bond is purchased, the buyer is lending money to a government, company, or other organization. Interest is paid to the bond owner on a schedule specified by the bond – typically every six months. The interest rate is fixed by the terms of the bond. If the company performs astronomically well, the bond still only pays according to those terms. It does not pay more. On the other hand, bonds pay the terms of the bonds regardless of poorer than expected company performance (unless the company goes bankrupt). Investors include bonds in their portfolio to provide stability, not higher returns. For long-term investment periods, the stock market has always beaten bond performance. For periods of a decade or less, however, stable bond interest can outperform the more volatile stock market. For most investors it makes sense to have at least part of their portfolio invested in bonds. Bonds can be subdivided into multiple asset classes. A bond is classified by it’s duration, it’s risk (as determined by Moody’s or Standard and Poor’s rating system) and by country of origin. For example one bond might be an international, long-term, Moody’s Baa bond while another is a US, short-term, Moody’s Aaa bond. You can learn details about bond rating systems in Section 5.1: Wikipedia Bond Credit Rating: http://www.golio.net/Chapter5.html An asset class can also be defined using any or all of these distinctions.

Stocks are a certificate of ownership in a company. As a stockholder, you are not personally liable for company debts or mismanagement -- even if you are a shareholder of a company that goes bankrupt. On the other hand, your participation in earnings has no limit. While you can lose no more than 100% of your investment, you can earn more than 10,000% on your stock if the company is very successful. For the greater risk of owning stocks, the investor demands greater returns. This is the reason that throughout history stocks have outperformed other investments over the long term. Stocks can be further distinguished by the size of the company selling the stock. Large companies are large-cap stocks. Small companies are small-cap stocks and medium sized companies are mid-cap stocks. Stocks can be classified along a second continuum as either growth or value stocks. Using these two classifications subdivides the stock asset class into 6 other possible asset classes. When a distinction between US companies and international companies is added, we end up with 12 possible asset classes. For example a company’s stock might be an international, large-cap, value stock while another stock is a US, small-cap growth stock, etc.

An asset allocation plan can be developed based simply on the stock/bond distinction. An AA could establish a target allocation of 60% stock and 40% bond for their portfolio. A reasonable rule-of-thumb for determining stock allocation is to compute (100 – [your age]) as a target stock percentage. Thus a 40 year old would choose a 60/40 stock/bond allocation. An investor who is comfortable with more risk might use (110 – age) while a conservative investor might choose (90 – age) to compute a stock target. Such a plan isn’t complete until the investor decides how he/she will own stocks and bonds. An investor can choose to pick individual stocks and bonds through a brokerage house, or buy them through mutual funds. For an individual, diversification is most easily achieved by choosing mutual funds. A very good first order asset allocation plan could be based on only two mutual funds: 1) A broad stock market index fund, and 2) a broad bond market index fund. Historically, for periods of at least two decades, an investor with an asset allocation plan with only these two, low cost index funds would have outperformed over 80% of all other investors.

Investors may be able to improve on the above fundamental asset allocation plan by using the more refined divisions of stocks and bonds as asset class definitions. The 60% stock allocation, for example, might be broken down into 40% US stocks and 20% international stocks. Further subdivisions that consider the growth-value and/or size continuum can also be applied. Bond class definitions can similarly be applied. In addition, real estate and/or commodities can be added to the target asset classes.

Not all asset class distinctions are useful to an investor. Adding more asset classes without understanding correlations between those assets does not help a portfolio in terms of risk or reward. In other words, more asset classes is not necessarily an indicator of a more sophisticated investor.

For more on asset allocations, refer to http://www.golio.net/Chapter6.html Section 6.2.

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