Asset allocation, in basic terms, is the division of investment assets among numerous asset classes. At its simplest, one would divide their investment dollars among stocks, bonds and cash, with the percentage allocated to each determined by the individual’s time horizon and risk tolerance. The justification for allocating among various asset classes is the notion that different types of investments will have returns that do not correlate with one another and, therefore, will potentially reduce the overall variability of investment returns.
When implementing an asset allocation there are three approaches available to the investor. The most common approach is a strategic allocation, where one creates an asset mix designed to balance expected risk and anticipated return over a long-term time horizon. Periodic rebalancing is important in keeping the risk/reward at a suitable level.
Tactical asset allocation takes a more active approach to investments management and is based on the belief that one is able to outperform the market by moving between assets classes, asset sectors, or individual positions. For some individuals this approach entails looking for the “hot dot,” but for others it is more of a contrarian approach of investing in areas of the market that have recently underperformed.
The final method is a hybrid of the first two strategies and is referred to as the core-satellite approach. Consisting of 50% to 80% of one’s investments, the core holdings consist of stocks, bonds, mutual funds and/or exchange traded funds (ETFs) that represent an asset mix consistent with the individual’s appropriate strategic allocation. The satellite holdings are more active and reflect one’s thoughts on short-term opportunities.
Any asset allocation is built on historical asset class returns and risk (volatility) measures. The most common approach is to simply use the historical data to make estimates of expected annual returns and their correlating volatility to create an allocation. Such an approach makes for a nice visual presentation, is easily understood by the average investor, and is simple to implement. Unfortunately, the historic data is not reliable.
It is true that when we review past performance we may receive a better understanding of how all asset classes have performed. Unfortunately, for some asset classes the data go back to the early 20th century while other asset classes do not have accurate information available prior to the 1970s. Even if we account for the data issues, there is no guarantee that one’s actual performance will equate with these averages. History has shown that asset classes get overvalued and undervalued but typically revert to their mean. Interest rates, market valuations, investor sentiment, and the general economy all factor into how every asset class performs over the short to medium term. It is nice to know what has happened historically, but one should be looking forward and not backwards when making allocation decisions.
Right now we are in a very difficult investing environment. With interest rates at unprecedented low levels, the asset classes traditionally thought of as low risk – fixed income and cash – are the areas of the market that are extremely unattractive. Fortunately there are attractive investing opportunities available, such as equities and emerging market debt, which we believe have the potential to produce acceptable returns. These attractive asset classes, however, are the traditionally higher volatility asset classes. Going forward it is reasonable to expect more volatility from an investment portfolio.
Historically in our opinion, more portfolio volatility over long periods of time has produced enhanced annualized returns. In the current environment, we do not expect that to be the case. Future asset class returns are unlikely to match historical averages for a number of years. At the start of the great bull market that started in August, 1982 the market Price-to-Earnings Ratio (P/E), (as measured by the S&P 500 index), was approximately 6. When the markets peaked in March, 2000 the market P/E was 27. Since that peak, we have seen earnings continue to increase and market multiples contract. Currently the market is trading at a not very expensive but not very cheap 13x forward earnings expectations.
There are compounding factors beyond the current pricing of the variable asset classes. Since the global financial crisis in 2008 the United States has been in an economic rebalancing phase with the Federal Government increasing its debt load as households and corporations rebalance their balance sheets. The result has been a slow, drawn out economic recovery with historically poor job growth. This situation should continue until there are enough jobs in this country to stimulate a consumer demand cycle of economic growth.
Globally there are issues surrounding the other three economic centers – Europe, China, and Japan. Europe is going through their own economic crisis while China deals with a slowing growth rate and inflation issues. Japan, the world’s fourth largest economy, has an unsustainable debt-to-GDP level over 225% and no immediate plans to address the issue.
As a result, we are looking at a very unusual investment environment at a time when a record number of Americans are getting close to retirement age. We have “safe” assets that do not produce nearly enough income to fund a 25 year retirement at the same time we have above average volatility in equities with contracting P/E multiples. So what’s an investor to do?
Addressing the Asset Allocation Dilemma
As discussed earlier, traditional asset allocation has focused on the risk/reward spectrum, based on historical returns of the various asset classes. Historical data is nice, but it does not reflect the challenging environment investors currently face. To be financially successful, investors must stop looking through the rearview mirror and start looking at the realities ahead. We live in a more volatile, globally integrated world where economic growth is no longer centered in the United States. We believe investors need to take a less traditional approach to securing their financial future.
The challenge is to change the focus from simple growth of assets to a growth plus growth –of-income approach. The growth of the income stream should come from all asset classes, not just bonds. Basic growth investing typically works during bull markets. During the great bull market of 1982 through 1999, for example, investing was as simple as buy some bonds for stability and buy some stocks for growth. It was easy and effective. It has not worked since.
Going forward, we believe investors can expect the returns they receive to be a combination of low growth in the asset base plus income received from the investments held. With any allocation there is usually some income coming into the portfolio through the bond and cash positions, but no consideration to the growth of that income stream over time. This needs to change. In today’s low interest rate environment it is impossible for most investors to rely on the paltry interest from lower-risk bonds, bank issued CDs or Municipal Bonds.
A more dynamic, diversified approach is needed. Today, investors should consider diversifying their bond allocation among various types of income producing securities. The equity positions may be concentrated in companies that have historically paid dividends and have a history of increasing the dividend to shareholders over time. All asset types can be held as a collection of individual securities, via mutual funds or exchange traded funds (ETFs), and might include both foreign and domestic investments.
What your personal asset allocation looks like should not be based on any generic model or investment strategy, but on your specific circumstances. We live in an ever changing world where the investors of today face issues our parents and grandparents never needed to consider. Thirty years ago, retirement planning for most families included streams of income from an employer pension, from social security, and from personal savings. Today, very few pension plans exist and changes to social security benefits appear likely. Step number one, then, should be assessing your current financial situation and goals.
Once you know where you are, the next step would be to plan into the future and see how your current goals stack up against reality. What percentage of your income do you plan on saving? What do you want life to look like? What big financial moments do you have planned for the future (college, new house, weddings)? For a young couple this likely means balancing saving for retirement while planning for other expenses. For a family within 10 years of expected retirement this would likely be more retirement focused.
To determine your personal mix of investment assets it is necessary to have a realistic understanding of where you are financially, what your savings plan is, and where you want to be in the future. Once you have a financial assessment and a plan, the mix of stocks, bonds and cash can be determined. Within the general investment allocation it is important to have a dynamic, diversified mix of assets with a focus on both the growth of the assets and the growth of the income those investments produce.
At Magellan Financial we have developed a retirement planning methodology over the last 25 years that has assisted many pre-retirees and retirees to make better asset allocation decisions by understanding their financial situation. To schedule an initial consultation or learn more about how Magellan Financial can help, please call us at 610-437-5650 or email us at Rob.Cahill@WFAFINET.com.
This and/or the accompanying statistical information was prepared by or obtained from sources that Magellan Financial, Inc believes to be reliable, but its accuracy is not guaranteed. The report herein is not a complete analysis of every material fact in respect to any company, industry or security. The opinions expressed here reflect the judgment of the author as of the date of the report and are subject to change without notice. The material has been prepared or is distributed solely for information purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy.