Thursday, November 09, 2006

Asset Allocation: Pros and Cons

Financial professionals (FPs) often advise investors the most important aspect to achieving satisfactory investment returns is to determine ones appropriate asset allocation. Financial professionals will tell investors that 92% of ones return is determined by their asset allocation decision.

The 92% figure comes from a study by Brinson, Hood, and Beebower (BHB). BHB studied ninety-one pension plans over the period 1974-1983. The study concluded “investment policy dominates investment strategy (market timing and security selection), explaining an average of 93.6% (later revised to 91.5%) of the variation in total plan returns.”

A number of researchers note FPs have drawn an incorrect conclusion from the BHB study. The 92% figure cited in the study was referring to variation (or volatility) of ones returns and not the total returns themselves. This issue was highlighted in an article by William Jahnke titled Its Time to Dump Static Asset Allocation.

The two most common asset allocation decisions are strategic and tactical. Strategic asset allocation is the determination of the amount of ones investments that are invested in stocks, bonds and cash. The allocation can be broken down further within each category, for example, large cap equities, small cap equities, etc. Tactical asset allocation involves moving ones investments away from the strategic allocation targets in an effort to invest in the asset style that appears to be undervalued or the one an investor believes will provide a higher return in the short run. To some, tactical asset allocation is referred to as market timing.

An investor must ask themselves what is the appropriate asset allocation. There isn’t one correct answer. For an investor whose investment assets are only sufficient to support their lifestyle, that investor should be concerned with losing principal in a down market. On the other hand, the investor needs to achieve a return at least equal to the rate of inflation so purchasing power is maintained. The best chance to achieve this result is to establish a core portfolio of high quality dividend growth stocks. These higher quality dividend paying stocks, historically, have lost less value in down markets. Conversely, in up markets, and over longer term time periods, the higher quality dividend paying equities have outperformed the S&P 500 Index. The investor can then build smaller investment positions around the core portfolio if the investor desires exposure to other equity asset classes.

The goal of a financial advisor should be to focus on an investor’s financial needs and goals over short and long term time horizons. From these goals and objectives, the FP should construct a portfolio that will strive to achieve a rate of return sufficient to grow ones investments to a level that equals or exceeds target asset levels developed in a financial plan. The benchmark for ones returns does not need to be a specific index, but should be the goals and objectives of each investor. If the S&P is down 20% in a specific year and an investor’s portfolio is down 18%, does this result achieve the target asset levels developed in the financial plan-not likely.

In conclusion, an investor should be aware of the fact the BHB study’s conclusion that 93.6% of an investor’s variation in returns is attributable to strategic asset allocation. The BHB study’s focus was on variation, or range of returns between the highs and lows. The BHB study did not address the allocation that would achieve the higher overall rate of return.

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