Determining the Asset Allocation That's Right for You

Obviously, we can't tell you everything about asset allocation strategy here in the free section. But we can give you a pretty clear idea about the material you can access if you subscribe to The Index Investor (for those interested in a more technical view of asset allocation, see our e-book, The Index Investor's Guide to Asset Allocation).

Before we introduce any numbers, let's start with some basic principles. First, every investor faces the challenge of balancing downside protection (against capital loss) with upside potential (for high returns). Second, research has shown that in general, people are more sensitive to losses than they are to gains of the same magnitude. Third, your need for downside protection is also a function of the length of your investment horizon (how long before you'll need the money) and whether or not you are making regular withdrawals from your savings (as would be the case, for example, if you were gradually drawing down your savings to pay your bills during retirement). The shorter the time before you need the money, and the more you're planning on taking out along the way, the more downside protection you need. Fourth, the degree of mismatch between your current and expected savings and your financial goals (absent a change elsewhere) tends in practice to create situations where the amount of downside protection you want is less than the amount you can afford (in terms of foregone returns on higher risk assets). In other words, there is usually a tradeoff between your lifestyle, your financial goals, and your asset allocation. As with so many other things in life, there is no free lunch here either!

Finally, different asset classes provide different degrees of downside protection and upside potential. Broadly speaking, our "home market" (we think of this as the market in which returns are denominated in the same currency as our liabilities) can be in one of three states: normal, high inflation, or deflation. In the normal state, we don't need as much downside protection as we do in the other states, and look to equity type investments to generate high returns for us. In the inflationary state, we look to asset classes like real return bonds and commodities (and possibly foreign bonds and real estate, but more on that later) to protect the purchasing power of our capital. In the deflationary state, we look to investment grade bonds to preserve our capital while maximizing our real returns.

Now let's move on to a basic quantitative example. One of the most important lessons about asset allocation is that, assuming you define your asset classes correctly, investing in more of them often increases your expected returns while asking you to take on no more risk than you would with a mix that uses fewer classes.

For example, John's portfolio contains a mix of 60% U.S. equities (invested in a fund that tracks a broad index like the Wilshire 5000) and 40% investment grade bonds (invested in a fund that tracks the Lehman Brothers Aggregate Bond Index). In real terms (that is, after the affect of inflation has been eliminated), we estimate that this portfolio will earn an average rate of return of 5.9% per year, with a standard deviation of 11.9%.

In contrast, Jane has considered a wider range of asset classes, including (in addition to domestic equities and investment grade bonds) real return bonds, foreign currency bonds, commercial property, commodities, foreign developed market equity, and emerging markets equity (with appropriate maximum limits on the riskier asset classes). The resulting mix of asset classes in her portfolio also has an expected standard deviation of 11.9%. But is also has an expected annual real return of 8.0%.

Does this matter? It sure does. Assume that both John and Jane start with $10,000. At the end of 20 years, John's portfolio has an expected value of $31,472, while Jane's expected value is $46,610 -- a difference of 48%. That can make a very big difference in the quality of life you enjoy after you retire.

Our monthly journal, The Index Investor, contains many feature articles on different aspects of asset allocation, as well as model portfolios for investors whose functional currencies include Australian, Canadian, and U.S. Dollars, Euro, Yen, Swiss Franc, Indian Rupee and Pounds Sterling.

These model portfolios are based on a number of input variables, including an investor's starting capital, expected future savings, desired accumulation goal, and the time horizon over which he or she wants to achieve it. The combination of these variables generates a minimum compound annual return the portfolio must earn to achieve the accumulation goal within the desired time period. Our model portfolios show the asset allocations and rebalancing strategies that maximize the probability of achieving these different minimum compound annual return targets.

Just as important, subscribers to The Index Investor can use pull-down menus to test the impact of changing their savings rates, accumulation goal, or time horizon. Some combinations have much higher probabilities of success than others, and we make it easy to understand the implications of the apparently confusing choices facing investors.

You may view a sample Model Portfolio Solution (which includes values for key input variables, the minimum required rate of return, both an asset allocation and rebalancing strategy, and the probability of achieving the specified accumulation goal).

As we have noted, once you have decided on your target asset allocation, you face another big decision: do you implement it through actively managed funds or through index funds?

The follow up question is of course: How to Implement Your Asset Allocation: Active Management or Indexing?

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