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Question Of The Month –May, 2009

Why Is Asset Allocation So Important?

Asset allocation involves dividing an investment portfolio among different asset categories, such as stocks, bonds, and cash. The process of determining which mix of assets to hold in your portfolio is a very personal one. The asset allocation that works best for you at any given point in your life will depend largely on your time horizon and your ability to tolerate risk.

Time Horizon - Your time horizon is the expected number of months, years, or decades you will be investing to achieve a particular financial goal. An investor with a longer time horizon may feel more comfortable taking on a riskier, or more volatile, investment because he or she can wait out slow economic cycles and the inevitable ups and downs of our markets. By contrast, an investor saving up for a teenager's college education would likely take on less risk because he or she has a shorter time horizon.

Risk Tolerance - Risk tolerance is your ability and willingness to lose some or all of your original investment in exchange for greater potential returns. An aggressive investor, or one with a high-risk tolerance, is more likely to risk losing money in order to get better results. A conservative investor, or one with a low-risk tolerance, tends to favor investments that will preserve his or her original investment. In the words of the famous saying, conservative investors keep a "bird in the hand," while aggressive investors seek "two in the bush."

When it comes to investing, asset allocation --spreading your assets among a variety of investments that have different return potentials and risk levels -- means not putting all your eggs into one investment basket. Since market cycles vary, diversification may allow you to offset possible losses in one investment type with potential gains in another and, as a result, may help you reduce your overall exposure to risk.

Many experts believe that the most important decision is how to divide your assets among the different asset classes. Spreading your assets out among different types of assets can help lower the risk of reaching retirement without enough money to live as comfortably as you would like.

There are two ways you can invest. 1. You can continually move your money from one investment to another, chasing the asset class that you think will do best under tomorrow’s conditions…or 2. You can simply spread your portfolio across a variety of investment types.

Regardless of whether the market is up or down, asset allocation is your most important investment decision. It would be a huge mistake to invest in only one asset class, whatever its potential, because if that market drops, your entire portfolio goes with it.

However the problem is that a good number of investors are looking for today’s top performing vehicle… the hottest technology stock, today’s hottest mutual fund, the CD with the highest yield and we overlook the issue of asset allocation. And, if we do that, we end up with no plan or a plan that does not match up with our needs. Your investments then can become too conservative, too risky or too focused on one objective.

How important is asset allocation? A classic study, originally done in 1985 by Gary Brinson found that 94 percent of a fund’s performance can be attributed to a sound asset allocation strategy. Shifting portfolio assets in and out of and between markets accounted for 2% of the variation. Individual security selection accounted for 4%.

It is not picking the individual winner. It is not timing the market. It is a sound asset allocation strategy… spreading your portfolio across a variety of investment types.

Sound asset allocation will increase your chances of getting the best return, while reducing risk. Even though the original study was done in 1985, the results have been replicated in a number of studies since then.

So, how have some model portfolios using asset allocation, performed over the past 82 years?

Model Portfolios – 1926 - 2008

Income

An income-oriented investor seeks current income with minimal risk to principal, is comfortable with only modest long-term growth of principal, and has a short- to mid-range investment time horizon.

100% bonds

Historical Risk/Return (1926–2008)
Average annual return	5.5%
Best year (1982)	32.6%
Worst year (1969)	–8.1%
Years with a loss	13

80% bonds / 20% stocks

Historical Risk/Return (1926–2008)
Average annual return	6.7%
Best year (1982)	29.8%
Worst year (1974)	–10.3%
Years with a loss	12

70% bonds / 30% stocks

Historical Risk/Return (1926–2008)
Average annual return	7.2%
Best year (1982)	28.4%
Worst year (1931)	–14.2%
Years with a loss	14

Balanced

A balanced-oriented investor seeks to reduce potential volatility by including income-generating investments in his or her portfolio and accepting moderate growth of principal, is willing to tolerate short-term price fluctuations, and has a mid- to long-range investment time horizon.

60% bonds / 40% stocks

Historical Risk/Return (1926–2008)
Average annual return	7.7%
Best year (1933)	27.9%
Worst year (1931)	–18.4%
Years with a loss	16

50% bonds / 50% stocks

Historical Risk/Return (1926–2008)
Average annual return	8.1%
Best year (1933)	32.3%
Worst year (1931)	–22.5%
Years with a loss	17

40% bonds / 60% stocks

Historical Risk/Return (1926–2008)
Average annual return	8.5%
Best year (1933)	36.7%
Worst year (1931)	–26.6%
Years with a loss	21

Growth

A growth-oriented investor seeks to maximize the long-term potential for growth of principal, is willing to tolerate potential large short-term price fluctuations, and has a long-term investment time horizon. Generating current income is not a primary goal.

30% bonds / 70% stocks

Historical Risk/Return (1926–2008)
Average annual return	8.9%
Best year (1933)	41.1%
Worst year (1931)	–30.7%
Years with a loss	22

20% bonds / 80% stocks

Historical Risk/Return (1926–2008)
Average annual return	9.2%
Best year (1933)	45.4%
Worst year (1931)	–34.9%
Years with a loss	23

100% stocks

Historical Risk/Return (1926–2008)
Average annual return	9.6%
Best year (1933)	54.2%
Worst year (1931)	–43.1%
Years with a loss	25

Annual stock market returns are calculated using the Standard & Poor's 500 Index from 1926 through 1970, the Dow Jones Wilshire 5000 Index from 1971 through April 22, 2005, and the MSCI US Broad Market Index thereafter.

Annual bond market returns are calculated using the Standard & Poor's High Grade Corporate Index from 1926 through 1968, the Citigroup High Grade Index from 1969 through 1972, the Lehman Brothers U.S. Long Credit AA Index from 1973 through 1975, and the Barclays Capital U.S. Aggregate Bond Index thereafter.

Annual returns on cash investments are calculated using the Citigroup 3-Month Treasury Bill Index.