Asset allocation

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Asset allocation is an investment strategy that attempts to balance risk versus reward by adjusting the percentage of each asset in an investment portfolio according to the investors risk tolerance, goals and investment time frame.[1]
Contents
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1 Description 2 Asset classes and strategies 3 Academic studies

3.1 Performance indicators

4 Return versus risk trade-off 5 See also 6 References 7 External links

Description

An investment portfolio with a diverse asset allocation

Many financial experts say that asset allocation is an important factor in determining returns for an investment portfolio.[2] Asset allocation is based on the principle that different assets perform differently in different market and economic conditions. A fundamental justification for asset allocation is the notion that different asset classes offer returns that are not perfectly correlated, hence diversification reduces the overall risk in terms of the variability of returns for a given level of expected return. Asset diversification has been described as "the only free lunch you will find in the investment game".[3] Academic research has painstakingly explained the importance of asset allocation and the problems of active management (see academic studies section below). Although risk is reduced as long as correlations are not perfect, it is typically forecast (wholly or in part) based on statistical relationships (like correlation and variance) that existed over some past period. Expectations for return are often derived in the same way. When such backward-looking approaches are used to forecast future returns or risks using the traditional mean-variance optimization approach to asset allocation of modern portfolio theory, the strategy is, in fact, predicting future risks and returns based on past history. As there is no guarantee that past relationships will continue in the future, this is one of the "weak links" in traditional asset allocation strategies as derived from [4]. Other, more subtle weaknesses include the "butterfly effect", by which seemingly minor errors in forecasting lead to recommended allocations that are grossly skewed from investment mandates and/or impracticaloften even violating an investment manager's "common sense" understanding of a tenable portfolio-allocation strategy.

[edit]Asset

classes and strategies

There are many types of assets that may or may not be included in an asset allocation strategy:

cash and cash equivalents (e.g., certificate of deposit, money market funds) fixed interest securities such as Bonds: investment-grade or junk (high-yield); government or corporate; short-term, intermediate, long-term; domestic, foreign, emerging markets; or Convertible security

stocks: value, dividend, growth, sector specific or preferred (or a "blend" of any two or more of the preceding); large-cap versus mid-cap, small-cap or micro-cap; public equities versus private equities, domestic, foreign (developed), emerging or frontier markets

commercial or residential real estate (also REITs) natural resources: agriculture, forestry and livestock; energy or oil and gas distribution; carbon or water precious metals industrial metals and infrastructure collectibles such as art, coins, or stamps

insurance products (annuity, life settlements, catastrophe bonds, personal life insurance products, etc.) derivatives such as long-short or market neutral strategies, options, collateralized debt and futures foreign currency venture capital, leveraged buyout, merger arbitrage or distressed securities

There are several types of asset allocation strategies based on investment goals, risk tolerance, time frames and diversification: strategic, tactical, and core-satellite. Strategic Asset Allocation the primary goal of a strategic asset allocation is to create an asset mix that will provide the optimal balance between expected risk and return for a long-term investment horizon[5]. Tactical Asset Allocation method in which an investor takes a more active approach that tries to position a portfolio into those assets, sectors, or individual stocks that show the most potential for gains [6][7]. Core-Satellite Asset Allocation is more or less a hybrid of both the strategic and tactical allocations mentioned above[8]. Systematic Asset Allocation is another approach which depends on three assumptions. These are-

The markets provide explicit information about the available returns. The relative expected returns reflect consensus. Expected returns provide clues to actual returns.

[edit]Academic

studies

In 1986, Gary P. Brinson, L. Randolph Hood, and SEI's Gilbert L. Beebower (BHB) published a study about asset allocation of 91 large pension funds measured from 1974 to 1983.[9] They replaced the pension funds' stock, bond, and cash selections with corresponding market indexes. The indexed quarterly return were found to be higher than pension plan's actual quarterly return. The two quarterly return series' linear correlation was measured at 96.7%, with shared variance of 93.6%. A 1991 follow-up study by Brinson, Singer, and Beebower measured a variance of 91.5%.[10] The conclusion of the study was that replacing active choices with simple asset classes worked just as well as, if not even better than, professional pension managers. Also, a small number of asset classes was sufficient for financial planning. Financial advisors often pointed to this study to support the idea that asset allocation is more important than all other concerns, which the BHB study lumped together as "market timing".[11] One problem with the Brinson study was that the cost factor in the two return series was not clearly discussed. However, in response to a letter to the editor, Hood noted that the returns series were gross of management fees.[12] In 1997, William Jahnke initiated debate on this topic, attacking the BHB study in a paper titled The Asset Allocation Hoax.[13] The Jahnke discussion appeared in the Journal of Financial Planning as an opinion piece, not a peer reviewed article. Jahnke's main criticism, still undisputed, was that BHB's use of quarterly data

dampens the impact of compounding slight portfolio disparities over time, relative to the benchmark. One could compound 2% and 2.15% quarterly over 20 years and see the sizable difference in cumulative return. However, the difference is still 15 basis points (hundredths of a percent) per quarter; the difference is one of perception, not fact. In 2000, Ibbotson and Kaplan used five asset classes in their study Does Asset Allocation Policy Explain 40, 90, or 100 Percent of Performance?[14] The asset classes included were large-cap US stock, small-cap US stock, non-US stock, US bonds, and cash. Ibbotson and Kaplan examined the 10 year return of 94 US balanced mutual funds versus the corresponding indexed returns. This time, after properly adjusting for the cost of running index funds, the actual returns again failed to beat index returns. The linear correlation between monthly index return series and the actual monthly actual return series was measured at 90.2%, with shared variance of 81.4%. Ibbotson concluded 1) that asset allocation explained 40% of the variation of returns across funds, and 2) that it explained virtually 100% of the level of fund returns. Gary Brinson has expressed his general agreement with the Ibbotson-Kaplan conclusions. In both studies, it is misleading to make statements such as "asset allocation explains 93.6% of investment return".[15] Even "asset allocation explains 93.6% of quarterly performance variance" leaves much to be desired, because the shared variance could be from pension funds' operating structure.[14] Hood, however, rejects this interpretation on the grounds that pension plans in particular cannot cross-share risks and that they are explicitly singular entities, rendering shared variance irrelevant.[12] The statistics were most helpful when used to demonstrate the similarity of the index return series and the actual return series. A 2000 paper by Meir Statman found that using the same parameters that explained BHB's 93.6% variance result, a hypothetical financial advisor with perfect foresight in tactical asset allocation performed 8.1% better per year, yet the strategic asset allocation still explained 89.4% of the variance.[11] Thus, explaining variance does not explain performance. Statman says that strategic asset allocation is movement along the efficient frontier, whereas tactical asset allocation involves movement of the efficient frontier. A more common sense explanation of the Brinson, Hood, and Beebower study is that asset allocation explains more than 90% of the volatility of returns of an overall portfolio, but will not explain the ending results of your portfolio over long periods of time. Hood notes in his review of the material over 20 years, however, that explaining performance over time is possible with the BHB approach but was not the focus of the original paper. [16] Bekkers, Doeswijk and Lam (2009) investigate the diversification benefits for a portfolio by distinguishing ten different investment categories simultaneously in a mean-variance analysis as well as a market portfolio approach. The results suggest that real estate, commodities, and high yield add most value to the traditional asset mix of stocks, bonds, and cash. A study with such a broad coverage of asset classes has not been conducted before, not in the context of determining capital market expectations and performing a meanvariance analysis, neither in assessing the global market portfolio.[17]

[edit]Performance

indicators

McGuigan described an examination of funds that were in the top quartile of performance during 1983 to 1993.[18] During the second measurement period of 1993 to 2003, only 28.57% of the funds remained in the top quartile. 33.33% of the funds dropped to the second quartile. The rest of the funds dropped to the third or fourth quartile. In fact, low cost was a more reliable indicator of performance. Bogle noted that an examination of five-year performance data of large-cap blend funds revealed that the lowest cost quartile funds had the best performance, and the highest cost quartile funds had the worst performance.[19]

[edit]Return

versus risk trade-off

In asset allocation planning, the decision on the amount of stocks versus bonds in one's portfolio is a very important decision. Simply buying stocks without regard of a possible bear market can result in panic selling later. One's true risk tolerance can be hard to gauge until having experienced a real bear market with money invested in the market. Finding the proper balance is key.

Cumulative return after inflation from 2000-to-2002 bear market[20]

80% stock / 20% bond

34.35%

70% stock / 30% bond

25.81%

60% stock / 40% bond

19.99%

50% stock / 50% bond

13.87%

40% stock / 60% bond

7.46%

30% stock / 70% bond

0.74%

20% stock / 80% bond

+6.29%

Projected 10 year Cumulative return after inflation

(stock return 8% yearly, bond return 4.5% yearly, inflation 3% yearly [21]

80% stock / 20% bond

52%

70% stock / 30% bond

47%

60% stock / 40% bond

42%

50% stock / 50% bond

38%

40% stock / 60% bond

33%

30% stock / 70% bond

29%

20% stock / 80% bond

24%

The tables show why asset allocation is important. It determines an investor's future return, as well as the bear market burden that he or she will have to carry successfully to realize the returns.