Basic Truths About Asset Allocation:
A Consensus View Among the Experts
By William
Reichenstein
It is widely agreed that the asset
allocation decision is the most important one an investor will make.
How you split your investment funds among stocks, bonds, and cash
(that is, short-term debt) is more important than your choice of
stock mutual funds.
Experts, not
surprisingly, do not always agree on the precise allocations that
different types of investors should adhere to. Yet, in comparing
recommendations from published advisory sources, it is clear that
there exists a broad consensus about the appropriate mix among
stocks, bonds, and cash for most individuals during each stage of
their life cycle. Of course, all recommendations carry a disclaimer
that individual circumstances may dictate a mix that is quite
different.
Many individual
investors, though, resemble at least roughly the "typical" investor
profile. This article discusses some of the general guidelines that
can be gleaned from these broad recommendations for the "typical"
investor. And it notes some of the special circumstances that could
dictate an asset mix that differs from the consensus.
The Broad Asset Mixes
Table 1
summarizes the recommended mixes of stocks, bonds, and cash from
four well-known advisory sources. The suggested asset mixes include
stocks, bonds, and cash; they do not include real assets such as
one's home or other real estate. While one source explicitly assumes
that investors own their home, it is most likely that the other
sources implicitly make this assumption as well, and thus assume
investors have a real estate exposure.
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Table
1. Asset Allocation for the "Typical" Investor: The
Broad Consensus |
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Stocks
(%) |
Bonds
(%) |
Cash
(%) |
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High-risk investors; young investors |
70 -
80 |
15 -
25 |
0 - 5
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Medium
risk investors; investors approaching retirement
|
60 |
30 -
40 |
0 - 10
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Low-risk investors; retiring investors and retirees
|
40 -
50 |
40 -
50 |
5 - 20 |
|
Investors over age 70 |
20 -
30 |
60 |
10 -
20 |
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Sources: The Vanguard Retirement Investing Guide
(Irwin Press); T. Rowe Price Retirement Planning
Kit; "The Wall Street Journal Guide to Planning Your
Financial Future" (Lightbulb Press), by Kenneth M.
Morris, Alan M. Siegel and Virginia B. Morris; "A
Random Walk Down Wall Street" (Norton Press, 6th
edition) by Burton G. Malkiel |
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While the
recommendations vary, they are more similar than dissimilar, and
reflect key investment truths. Some of these truths are
self-evident, but they are so basic to investing that they are worth
explicitly restating. Others are not self-evident, but they are
important elements of a sound portfolio. Here is a run-down of the
"investment truths" derived from the recommendations' common
elements:
A fixed-weight
strategy, with rebalancing at least annually, is an excellent
strategy.
Each of the sources
recommends specific asset mixes at different points in an investor's
life cycle. In order to maintain a given asset mix, the portfolio
must be periodically rebalanced. The simple idea is that a stable
asset mix gives an investor a stable risk exposure that is
appropriate for his or her financial needs, which are typically
dictated by the stage in life.
A fixed-weight
strategy is a long-run contrarian strategy. When stocks rise from
being fairly valued to overvalued, the investor sells the overvalued
stocks and buys bonds (or cash), or when putting new money into the
portfolio purchases bonds or cash rather than stocks. When stocks
fall from being fairly valued to undervalued, the investor sells
bonds and buys the undervalued stocks, or uses new money to buy
stocks. In short, a fixed-weight strategy allows someone to profit
from market misvaluations while maintaining a stable risk exposure.
Avoid market
timing.
Market timing calls
for sharp swings in the stock/bond/cash mix based on expected
near-term market prospects. For example, a market timing service may
recommend shifting the stock allocation from 80% one month to 10%
the second and to 60% the third. By definition, market timing
advocates an unstable risk exposure. All sources are unanimous in
their discouragement of market timing.
A portfolio's risk
can be moderated by mixing stocks and debt.
Stocks are claims
against real assets. Bonds and cash are debt, usually promising
fixed returns. Stock and debt are fundamentally different animals
and, consequently, their returns tend not to follow similar patterns
to each other. Consequently, combining stocks and debt moderates the
portfolio's risk.
On a broader scale,
individuals who hold stocks and debt in their investment portfolio
and own their own home have their broad portfolio diversified among
stocks, debt, and real estate—three asset types whose returns do not
vary closely together.
The longer the
investment horizon, the larger the portion of the portfolio that
should be allocated to stocks.
Young investors who
are years from retirement can invest more of their portfolio in
stocks than the elderly. Although year-to-year stock returns are
volatile, the young can be reasonably confident that the good years
will more than offset the bad years over their investment horizon.
As you age and your investment horizon shortens, you are less
confident that there will be enough good years to offset the bad,
and the recommended allocation to stocks decreases.
Everyone should
have some exposure to stocks, even a conservative 80-year-old
couple.
Historically, the
returns on a portfolio of long-term Treasury bonds have been more
volatile (that is, riskier) than a portfolio with 90% bonds and 10%
common stocks. Stocks held alone are riskier than bonds held alone,
but due to the magic of diversification you can add some stock to an
all-bond portfolio and actually reduce the portfolio's risk.
Diversification
means not putting all your eggs in one basket even if the basket
looks safe. Since 1926, the volatility of an 80% bond/20% stock
portfolio has been equal to that of a 100% bond portfolio. This
helps explain why no one recommends a stock weight of less than 20%.
Examination of the
detailed recommendations of the sources reveals other widely-held
investment truths:
Diversify within
the stock portion of the portfolio. In particular, an investor
should always have an exposure to large-value and large-growth
stocks.
There are two
dimensions to investing in the stock market: size and style. Size
refers to the size of the firm. In general, the 500 stocks
comprising the S&P 500 are considered "large" stocks, which account
for almost 75% of the market value of all U.S. stocks.
Style refers to the
investment style or philosophy to which a company is most likely to
appeal. Growth investors seek growth stocks—firms with fast-growing
earnings. They tend to have low dividend yields, high price-earnings
ratios, and high price-to-book-value ratios. Value investors seek
value stocks—firms whose shares are selling below their "real"
value. They tend to have high dividend yields, low price-earnings
ratios, and low price-to-book ratios.
Diversification
within a stock portfolio would consist of investing some portion in
each of these areas—large- and small-capitalization stocks (with
proportions roughly equal to their weighting in the total stock
market, a 75%/25% large-cap/small-cap mix), and growth and value
stocks.
International
stocks should be a part of everyone's portfolio, with the possible
exception of the elderly.
Recommendations for
international exposure start at about 15% to 20% for younger
investors, and gradually decrease as one gets older. One source
recommends no exposure for those who are 75 or older.
Young investors
should put more emphasis on international stocks, small stocks, and
growth stocks while older investors should put more emphasis on
large-cap stocks, especially value stocks.
While broad
diversification is always encouraged, younger investors can take
more risk, and can therefore place greater emphasis on the riskier
portions of the stock market; older investors can still invest in
these areas, but their emphasis should be on more stable,
large-capitalization companies.
Investors can
avoid the emerging international stock markets.
Emerging stock
markets promise a wild and bumpy rise. Dramatic gains are possible,
but so are equally dramatic losses. Only one source mentions
emerging markets, and that source does not advocate an exposure to
emerging markets for investors who are in their late 30s or older.
The consensus view is than an investor can safely avoid these
stocks.
As one ages, shift
the bond portion of the portfolio from primarily long-term bonds to
primarily intermediate-term or short-term bonds.
Bond prices become
more stable as maturity shortens. Thus the advice to shorten bond
maturity as one ages is consistent with the other advice to move
toward assets with more stable prices.
As one ages, the
cash portion of the portfolio increases.
Increasing cash
assets is part of shortening the bond maturity for increased price
stability.
High-grade
corporate bonds and Treasury bonds of similar maturity are close
substitutes.
No one
distinguishes between buying high-grade corporate bonds or Treasury
bonds of similar maturity, because the returns on these bonds move
very closely together, although high-grade corporate bonds tend to
have slightly higher yields. In contrast, high-yield bonds have a
much higher default risk and consequently are lower-graded; these
are not close substitutes for high-grade corporate or Treasury
bonds.
Are You a "Typical" Investor for Your Age?
It is clear that
there is a broad consensus about the appropriate mix of stocks,
bonds, and cash for "typical" investors at different life cycle
stages. But are you a "typical" investor for your age, or should
your portfolio be different from the consensus portfolio?
There are at least
three reasons why your portfolio may differ from that of the
consensus:
- First, you may
be more or less risk tolerant than most investors your age.
- Second, your
unique circumstances, especially as they pertain to your
non-financial assets and liabilities, may dictate a different
portfolio.
- Third, today's
stock and bond market prospects may suggest a different asset
mix.
How do you know if you
have an average risk tolerance? While an investor's risk tolerance
is of critical concern, it is difficult to measure. Probably the
best approach to this tricky issue is to examine downside risk,
which indicates the amount a given mix could be expected to drop
during a severe bear market. If the recommended asset mix entails
too much risk, you should adopt a more conservative mix, reducing
the recommended stock allocation by 10 percentage points; if you
believe you can tolerate more risk, you can increase the stock
allocation by 10%.
The second factor
affecting an individual or family's target asset mix involves its
non-financial assets and liabilities. These include real assets such
as the family home, other real estate, a family business, and
prospects for inheritance (whether certain or very likely). It also
includes liabilities like a mortgage and the future costs of college
education. It may also include the individual or family's human
capital (that is, future income). While there are an infinite number
of potential unique circumstances that may affect one's target asset
mix, here are the most common circumstances:
- Suppose you
will eventually receive the assets in a trust that holds
$300,000 of high-grade bonds. This bond exposure outside of your
overall investment portfolio means that more, perhaps all, of
your investment portfolio can be allocated to stocks.
- Suppose the
family owns a risky business that is the main source of income
for the family. The high risk of this asset may suggest less
risk in the investment portfolio.
- Suppose you
have the flexibility to choose how much and how long to work
later in life. You can invest more of your money in stocks and
other risky assets than if you have no such flexibility. Of
course, if your future income is in doubt, you should not take
on as much risk in the retirement portfolio.
The third factor that
may cause you to stray from the consensus mix concerns market
prospects. Recall the unanimous disapproval of market timing, which
calls for sharp swings in the asset mix based on short-term market
prospects. However, the current state of investment knowledge is
mixed on the question of whether one should make modest changes in
their asset mix based on long-term market prospects. Theory and some
empirical evidence suggests that we have a limited ability to
predict whether, for example, stocks will do better or worse than
average over the next three years. Nobel-laureate Paul Samuelson
looked at the evidence on this issue and argues that it is
sufficient to warrant changing your target weights plus or minus 10%
at most. However, others would strongly argue that investors should
stick with a fixed-weight strategy, with rebalancing at least
annually.
Summary
A careful study of
recommended asset mixes from four prominent financial firms and
eminent experts indicates that they share much of the same advice: a
fixed-weight strategy is an excellent one; avoid market timing;
diversify across stocks and bonds; diversify within the stock
portion of the portfolio; and, as you age, shorten the maturity of
the fixed-income portion of the portfolio.
The recommendations
also reflect a broad consensus about the appropriate mix of bonds,
stocks, and cash for the "typical" individual during each stage of
his life cycle. However, there are times when an individual will not
reflect the "typical" profile, and may need to stray from the
consensus. An individual's target asset mix could vary from the
consensus mix due to: his risk tolerance and atypical non-financial
assets and liabilities, including human capital. In addition, an
investor may reasonably decide to let the actual mix vary modestly
from his target mix due to market prospects over the longer term.
Most of the shared
advice is basic—it reflects common elements of a sound portfolio.
But then, most of
what one needs to know about investing is basic.
William Reichenstein holds the Pat and
Thomas R. Powers Chair in Investment Management at Baylor University
in Waco, Texas. He thanks Burton Malkiel for helpful comments in the
preparation of the article.
© AAII Journal
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