THE RIGHT ASSET ALLOCATION IS CRITICAL

This is an area where traditional Wall Street thinking is very good. Several studies have shown that the overall performance of one's investment portfolio depends more on how it is allocated among the various asset classes than on any other factor or tactics employed. That may be a bit of an overstatement, but it is essentially correct. An outstanding book on the subject is The Intelligent Asset Allocator by William Bernstein (McGraw-Hill, 2001). It is available in many book stores and from on-line sellers. Although I don't agree with everything the author says, I think it is well worth reading.

U.S. stocks are generally the primary and largest asset class in a U.S. investor's portfolio. Often, they are subdivided by type (growth vs. value) or by market capitalization (large, medium, small). The allocation among the subdivisions is less important than the overall allocation to (U.S.) stocks. Overseas stocks are often considered to be a separate asset class. However, in recent years the performance of stocks in industrially developed foreign countries (Canada, Europe, Japan, Australia) has correlated fairly strongly with the U.S. markets. That results from near instanteous worldwide communications and the strong linking of economies. To a large extent, most overseas stock markets are essentially the same asset class as the broad U.S. stock market. Stocks of companies in so-called emerging markets can provide real divesification, often with higher risks, and be considered as a seperate asset class.

Bonds are probably the second most important and used asset class. They belong in the portfolios of all but the youngest investors with the longest time horizons or those who have almost no aversion to risk. As a rule, they are less volatile than stocks, and they have the advantage of producing steady streams of income that are generally much higher than the dividend yields of stocks. High-yield or "junk" bonds can be considered as a separate asset class with investment characteristics that are somewhat of a hybrid of those of stocks and bonds.

Money market funds, short-term treasury bills or other cash equivalents form another asset class that is important for more conservative portfolios. While they will not see an increase in value--capital gains--they will not fall either, so they provide the ultimate in risk reduction. At time yields on these instruments can be extremely low, but there are also times when yields have been fairly high, which makes them generally useful for providing current income.

There are many other asset classes such as real-estate related (REITS, mutual funds, direct ownership although that may not be very liquid), precious metals (stocks, mutual funds, coins, direct ownership), and commodities (related stocks, futures trading, hedge funds). These are less common than the above, but they can provide diversification and to the extent they are not correlated with the others, they can smooth out the change in the value of the portfolio, which is usually considered desireable.

The above list is not meant to be all inclusive. There are many possibilities and ways of classifying and subdividing the asset classes one might include in a portfolio. In a typical 401(k) or similar account, there generally are limited number of investment options, which are usually mutual funds or instruments such as stable value or guaranteed return options, both of which are essentially bond investments.

Developing an appropriate allocation for an individual investor depends on many factors, some of which are mentioned on the previous page. It well beyond the purpose of this web site to provide individual guidance. That should be done on a one-to-one basis, which MDP Associates can do. Instead, three simple sample allocations are used for illustrative purposes. These should not be considered as recommendations.

To keep things simple and understandable, only the three main asset classes above will be included in the samples. They are stocks, and to keep things even simpler, stocks will be represented by S&P 500 total return index, bonds as represented by ten-year treasuries, and money market funds. You might ask if that isn't too simple. The answer is no. It is all you really need to include in your portfolio. However, you may want to include additional asset classes or refine the stock holdings by considering subdivisions such as those discussed above or refine the bond holdings by short-term vs. long-term or corporate vs. treasury. Including additional classes has advantages that can be worth the increased complexity. The asset allocations below are for illustrative purposes, are realistic, but there is nothing wrong with adding additional asset classes if that is your preference.

The three that will be used for illustrative purposes on the following pages are:

The above are target allocations. In particular, rebalancing periodically will be done, which is more frequent and important when the risk reduction models are not employed than when those models are used. With the use of the tactical models, there will be times when all types of accounts will have more in the money market and less in stocks and/or bonds than the targets shown above. There will be periods when the models call for being entirely in cash.

The next page discusses the tactical risk reduction models, and that is followed by a page showing how the combination of the above asset allocations and the models works over a long period of time in both secular bull and bear markets.

Next page: tactical risk reduction models

Previous page: avoiding the danger

Return to retirement investing main page