Helping Manage Risk Through Asset AllocationSource: LPL Financial
The goal of every investment portfolio is to produce the most optimal outcome over a specific period of time. However, each investor's preferences are different. If we all desired the same balance of safety, performance, maintenance, and cost, we would all drive the same type of car. Achieving investment goals requires knowledge of what outcome would define success, whether that objective is realistic, and how to construct an asset allocation designed to meet that objective.
Realistic goals are important to a successful investment plan. Not even the most aggressive investor should expect returns at or above the long-term stock market average annualized performance of 11% as measured by the S&P 500 index, nor should a conservative, fixed-income investor expect returns much above the current bond yields of about 5% as measured by the yield on the Lehman Aggregate Bond index. An investor who is focused solely on attempting to meet or beat a particular index with his or her portfolio is better suited to asset-class-specific investing, rather than asset allocation, which is capable of delivering a far broader range of performance objectives.
It is important to note that in developing an asset allocation the goal is not to attempt to beat the market, but also to take advantage of the many other opportunities offered by the investment universe. In addition to the large-capitalization U.S. stocks represented by the major market indexes, a wide variety of investment instruments with unique features is available to investors. The range of LPL Financial Research asset allocation models provides carefully constructed vehicles (as different as Volvos and a Ferraris - yet equally as suited to their owners) to seek unique performance objectives. As a result, to measure each model's success achieving its stated investment objective, we blend the market indexes that represent that model's allocations to create the benchmark, rather than measure the model against any single market index.
Because individual assets are often volatile but don't move in synch with all other assets, different types of assets can be combined to effectively help manage risk, enhancing the predictability of portfolio returns. For example, a 60% stock and 40% bond asset allocation has, on average, delivered 85% of the total return of the S&P 500 by capturing about 75% of the upside of the stock market while only suffering about 35% of the downside, measured over rolling 12 month periods of time since 1960.*
The six investment objectives defined by LPL Financial Research correspond to asset allocations providing a full spectrum of long-term risk and return objectives. The primary difference in return and risk is determined by the mix between stocks and bonds. Since 1926, 26% of stock market and 8% of bond market returns were negative on a 12-month basis. However, only rarely - about 1% of the time - did both stocks and bonds post simultaneous year-over-year negative returns. Therefore, managing the stock/bond allocation can have a significant impact on the stability and predictability of portfolio performance.
In constructing asset allocations, analyzing historical data and detailed financial models is useful, but forward-looking thinking is also very important. Relationships can change over time, and future returns may differ from past returns for a variety of reasons. The past is not a perfect guide to what will unfold in the future. Asset class returns, risks, and interrelationships may structurally shift over time.
- For the past 20 years, total returns for bonds have been boosted by falling interest rates - a trend that is unlikely to continue. In the future, total returns on bonds may lag the long-term historical averages achieved when yields were much higher.
- The structure of the universe of growth stocks has changed over time. It was once a relatively defensive group of stocks dominated by the Health Care and Consumer Staples sectors. Now, with the Technology sector a much larger portion of the growth stock universe, its cyclicality has increased. The volatility of growth stocks may exceed the long-term historical average.
- The relationship, or correlation, between asset classes may differ from prior periods. For example, the correlation between stocks and bonds has changed over time. It has recently become negative, meaning that stock prices and bond prices move inversely to each other - providing greater portfolio diversification. This environment is similar to the one of the 1950s and 1960s and is in contrast to that of the 1980s and 1990s when stock and bond prices generally moved together. This relationship, key to managing portfolio risk, has changed several times during the past 75 years.
The best way to help manage risk - in investing or any other dynamic discipline - is through analysis and modeling. The extensive quantitative analysis of historical data and complex modeling of possible future outcomes form the basis of sound decision-making. However, the process cannot stop there. Because financial markets are ever changing, it is critical that the output of analytical models be fine-tuned using experience, expertise, and judgment. In short, over-reliance on the raw data produced by a model can be problematic if that which is being measured is evolving and changing. And financial markets are evolving.
At LPL Financial Research the team charged with the responsibility of defining and managing the asset allocations is the Investment Strategy Group (ISG). The members of the ISG are Lincoln Anderson, Jeffrey Kleintop, John Canally, and Anthony Valeri.
This article was prepared by LPL Financial.
Asset Allocation does not ensure a profit or protection against a loss.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and are subject to availability and change in price.
Stock investing involves risk including loss of principal.
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