Asset Allocation

Smart investors have long recognized the importance of asset allocation, or how you divide your investable income among asset classes. Asset allocation will probably have more influence on your future investment returns than any other decision you make. Studies have shown that asset allocation accounts for over 90% of the disparity in returns among different investment portfolios (Financial Analysts Journal, 1991). In other words, asset allocation has a much greater influence on future returns than any purported skill in stock-picking or market timing.

For most investors, the primary asset classes are cash investments, bonds, and stocks. Cash investments include checking and savings accounts, money market funds and CDs. This is money that you use for daily living and for any unexpected expenses that might arise. Bonds are debt securities issued by governments and corporations. When you purchase a bond, you are in fact loaning money to the debt issuer. The debt is then repaid with interest via periodic installments (coupon payments) and/or a lump sum payment at the bond's maturity date. The least risky bonds are treasury bonds, which are backed by the full faith and credit of the U.S. government. At the other extreme are junk bonds, which are issued by corporations with less than stellar credit ratings. In return for assuming higher risk, investors in junk bonds receive higher interest payments (unless of course the sponsoring company defaults). In general, bonds are riskier than cash investments and pay slightly higher rates of return.

Stocks represent partial ownership, or equity, in a public corporation. As a shareholder, you can benefit by receiving periodic dividend payments or from a rise in the stock price. Stocks are generally more risky than cash investments or bonds, and they have historically provided higher rates of return. Over the long run, they have proven to be the best hedge against inflation.

So how do you decide how to distribute your investments among the various asset classes? Most financial advisors recommend keeping at least three times your monthly pre-tax salary in cash investments. To be on the safe side, I suggest setting aside half a year's income in a money market fund.

How do you choose appropriate allocations of stocks and bonds? This decision should be based on your personal goals, your risk tolerance, and the stability of your income stream. An aggressive investor with a high risk tolerance and dependable salary would probably choose a more aggressive strategy than a risk-averse investor with uncertain job security. To give you some ballpark figures, an aggressive investor might allocate 80% of his portfolio to stocks, while a very conservative investor might limit his stock allocation to 20 or 30%.

Financial advisors will usually ask about your investment time horizon when recommending an asset allocation strategy. Conventional wisdom holds that a younger investor can assume more risk than an older investor due to the difference in their time horizons. From a purely mathematical standpoint, this advice does not hold up. There may some psychological payoff to adopting a more conservative asset allocation as you grow older, but that should be assessed on an individual basis.

November 1, 2000

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