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Business matters Asset allocation an important decision

February 16, 2011

By Staff Reporter

By Kevin FitzGerald

I have been investing for a number of years, but recently I’ve become concerned that I may be taking too much risk. I’ve read some articles that talked about asset allocation, but I’m not sure exactly what it is and how it might apply to me. Could you comment?

– A.C., Long Island.

Asset allocation is the first decision an investor should make, and some say it is the most important. According to The Wall Street Journal (Nov. 3, 1995) “over the decades, studies have found that the asset-allocation decision is more important to investment success than decisions about which individual stocks or bonds to buy.”

Movements in the stock, bond and cash markets are driven by variables such as economic conditions, inflation and corporate profit expectations. How these variables interact to form an overall investment environment will determine the attractiveness of each asset class. For instance, high short-term interest rates may be negative for the stock market, meaning an investor might do better having a portfolio weighted more toward cash equivalents.

But how do you determine the best asset allocation at a given point in time? While advice based on sound asset allocation principles can be very valuable, investors should be aware that all asset allocation strategies are not created equal. Investment strategists use a variety of techniques to arrive at recommended asset mixes. Because there is no “standard” of asset allocation, the advice will vary from one asset allocator to another. Take, for example, a story in The Wall Street Journal on May 10, 1996. Wilshire Associates, a company that tracks the asset allocation advice of major brokerage firms for the Journal, reported that on the same day in 1996, brokerage firms were recommending bond exposures ranging from 10 percent to 50 percent of an investor’s portfolio.

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According to recent studies, some of the best asset allocation advice comes from strategists who use computer models based on completely objective information to determine recommended asset weightings. For example, a computer-based asset allocation model might use historical patterns of markets and market relationships to arrive at allocation decisions.

Over the last 70 years, stocks have tended to outperform all other types of investments, offering an average annual return of 10.5 percent, compared with 5.2 percent for long-term government bonds and 3.7 percent for treasury bills. At the same time, stocks are considerably more volatile than bonds or T-bills, and subsequently offer a greater degree of risk. An asset-allocation model would compare the current expected returns of each asset type, and compare those returns against what have been normal relationships in the past. Since stocks are historically riskier than bonds or cash, stocks should also offer a greater potential for return since the investor is assuming additional risk. This is known as the “risk premium.” When the current expected return from stocks is greater than the risks, stocks would be considered more attractive than bonds or cash, and the recommended percentage of stocks in a portfolio would be higher.

Investors should consider several factors when evaluating asset allocation methods. First, look for the track record. Look for an asset allocation model with a published proven track record of stable, above-average returns over the long term: five or more years. Keep in mind that track records refer to theoretical portfolios and market indices; real world returns may differ due to transaction costs and actual performance of specific securities.

Second, be sure that the asset allocation model uses a totally objective approach, taking the emotion out of investment decisions. Finally, the asset allocation advice is by its nature often contrary to current market sentiment, following a good asset allocation model in a disciplined manner, regardless of current market trends, can enable investors to achieve superior returns with minimized risk.

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