Is your asset allocation right for you?

Asset allocation is the widely-used term referring to how an investor distributes investments among various asset classes, such as cash, bonds, stocks, and alternative investments. The importance of asset allocation is supported by academic  research, which suggests that the allocation explains 90% or more of performance. Asset allocation also accounts for the amount of volatility in the portfolio.

Sample portfolios illustrate the relationship of risk and return
The characteristics of risk and return go hand in hand. Investors willing to accept higher levels of risk and volatility are normally rewarded with higher returns over the long term. Investors who do not wish to accept risk or volatility must accept lower returns.

See the comparison below showing returns from different allocations of stocks (S&P 500) and bonds (5-year Treasury Notes) from January 1950 through December 2008:

Maintain a long-term perspective
From this comparison, you can see that combining stocks with bonds reduced the risks (the worst 12-month returns) more than it reduced the benefits (the average 12-month returns). Importantly, if you can maintain a longer-term time horizon, such as 5 to 10 years, that will mitigate your downside. You can then accept a more aggressive allocation, which will give you the potential to achieve higher returns.

Combine low correlating assets
The concept of diversification is based on the fact that
asset classes behave differently over time. The correlation
of the S&P 500 to U.S. Bonds is 0.23. By combining low correlating assets such as these, you have the ability to lower your risk without commensurately reducing your return.
Beyond the basic overall mix of asset classes, you have the ability to further diversify your portfolio within those classes.

The key to reducing volatility in a portfolio is to combine low correlating types of investments to get the benefits of diversification. If asset types are too highly correlated, they will tend to move in lockstep with each other and therefore will not work to reduce risk. For example, if you combine holdings in Pepsico, Inc. and Coca-Cola Co., you are not diversifying because these two stocks are highly correlated. Conversely, if you combine U.S. large cap stocks with international stocks, you are effectively diversifying since these asset classes have lower correlations to each other.

Get the right mix
Generally speaking, the longer time-horizon you have, the more ability you have to ride out the ups and downs of the market in pursuit of a higher average annual return potential.

The shorter your time frame, or the closer you are to needing to withdraw funds, the more important it is to allocate a portion of your portfolio conservatively, or in safer investments. This will help you avoid the undesirable consequence of having to liquidate stocks while in a market downturn.

Several rules of thumb may help you decide what percent
of your portfolio you should invest in bonds or other less volatile investments. Vanguard founder Jack Bogle recommends 100 minus your age as the approximate percentage of your stock exposure. Many financial advisors advocate having 10 years’ worth of income allocated to safe investments upon starting withdrawals from a portfolio.

Lastly, there is always the sleep factor approach. You may have too much risk in your portfolio if it keeps you up at night. Sleep well.

For more information, please contact one of our Schenck Investment Solutions LLC advisors, or call Kathy Lakritz
at 888-556-5580 or 414-465-5557.

Kathleen A. Lakritz, CFA, CFP®, is an investment manager with Schenck Investment Solutions LLC. Kathy is based in Milwaukee, where her areas of specialization include personal investing, managing retirement plan assets, portfolio analysis, asset allocation, security review, retirement planning, and portfolio construction.

March 2009