Asset Allocation 101: Putting Together The Asset Mix To Meet Your Long-Term Goals

Contrary to what the financial media would have us believe, a financial fortune is not made—or retained—by exploiting hot stock tips or by jumping from fund to fund based on the latest "Top 10" list. In fact, selection of individual securities doesn't even make the short list of the top few most important portfolio decisions you will make.

Ultimately, far less exciting factors will make or break your investment program. These factors include how much you add or withdraw from the portfolio each year (reinvestment or withdrawal rate) ; the presence of significant concentrations in a specific asset (diversification); how much time the portfolio has to work for you (time horizon), and—what I will focus on here—how investments are made across broad categories such as stocks, bonds, cash, and other classes (asset allocation).

The goal is of asset preservation and long-term growth is to find a mix of investments that can generate the best return for the least amount of risk. Control the interim variability of a portfolio by selecting categories (classes) of investments that do not move in tandem. Ideally, different asset classes will march to different economic and fundamental drummers, allowing the portfolio to grow at a reasonable pace with a tolerable amount of interim variability. While this strategy can trim some of the short-term peaks from positive performance, it should serve to mitigate downside during depressed markets. Thoughtful, diverse asset allocation can help to ensure your ability to meet your long-term financial obligations, and allow you to escape sweating day-to-day portfolio balances and market nuances.

How do you fit all of these investment pieces together? Start with a basic understanding of the attributes of core asset classes and how they can work together to provide income, stability, and/or growth. Armed with this knowledge, conduct a realistic assessment of your own needs and goals—attaching specific dollar requirements and timelines. Earmark specific assets to meet particular shorter and intermediate needs. Invest the rest for the long term.

Step 1: Basic asset classes

The investment business has become exceedingly complicated over the past two or three decades. There are more than 7,000 equities in the U.S. alone (with thousands more on dozens of international exchanges), 8,000 mutual funds, thousands of hedge funds, and tens of thousands of brokers, consultants, and money managers trying to convince you that whatever investment they are purveying is better than the rest. However, as David F. Swensen, the well-regarded head of Yale's investment funds, said in his recent book Unconventional Success, "As a general rule of thumb, the more complexity that exists in a Wall Street creation, the faster and farther investors should run."

Despite the mind-numbing array of choices, for most individuals, the tried-and-true categories of stocks, bonds, and cash can constitute the core of a well-rounded investment portfolio. When evaluating the asset classes you might include, keep these overarching attributes in mind:

1. There is still no such thing as a free lunch. Risk and return are related, but inversely. In general, the more return a given asset class is capable of generating, the greater the degree of inherent short-term variability ("risk").
2. That said, even in the most volatile asset classes, short-term swings tend to smooth themselves out over the long haul. Note that factors (1) and (2) are vital as you address both how many absolute dollars you will need each year or by a specific date (capital preservation is important), and the length of time for which your portfolio must be able to generate a specific inflation-adjusted cash flow (long-term growth and maintenance of purchasing power is critical).
3. Day-to-day price volatility is not the only investment risk; over the long run, it's not even the most important. Inflation, with its negative impact on the purchasing power of your portfolio over time, is the most potent long-term threat.
4. You cannot control near-term price movements in the investment markets, nor can you (or anyone else, for that matter) accurately predict market reactions or levels. You do, however, have control over your own spending and whether your finances are handled in a tax-efficient manner.
5. Over the very long term, asset classes tend to revert toward sustainable long-term fundamental growth rates for the specific asset class. It is critical to use realistic long-term rates of return as you plot your investment strategy against your long-term cash flow needs.

Cash—Money market, certificates of deposit, savings accounts

Cash assets generate lower returns, but provide the maximum amount of principal preservation. Emergency funds and monies needed to fund major short-term expenses are typically kept in cash investments. Since 1925, according to Ibbotson and Associates (a key aggregator of statistics on the historical performance of various asset classes) , U.S. Treasury Bills have generated a compound annual return of 3.7%. Ibbotson data also notes that the standard range of returns (the "standard deviation") for Treasuries has been between 0.5 and 6.9%, which illustrates their stable nature.

Bonds—Debt instruments

When you purchase a bond, you are temporarily loaning your cash to someone else—such as the U.S. Government, a government agency, a municipality, or a corporation. In return for giving up the right to use your money during the term of the bond, you are paid a predetermined amount of income ("coupon" or "interest"). At the end of the loan period, you are repaid your original principal, assuming the issuer is still solvent.

Bonds typically provide a higher income than cash investments, because the bondholder is loaning money for a longer period of time and/or loaning money to an issuer whose creditworthiness may not be guaranteed. Typically, the longer the time to the maturity of the bond and/or the "riskier" the perception of the debtor, the higher the yield—to compensate the owner for the potential risk. Ibbotson data shows that the compound average annual return from intermediate government bonds has been 5.3% since 1925, in a range of –0.5 to 11.1%. Note that both the yield and the annual range of possibilities in any given year are wider than is seen with cash. This relationship is to be expected, since investors must be compensated for taking on more risk.

Fixed-income investments can provide an important source of steady income for a portfolio, since the future stream of interest payments is known at the time each bond is purchased. Fixed-income investments are often an important part of the overall asset mix for investors who need an investment portfolio to support sizeable annual withdrawals (of more than 2% of the asset base annually). Fixed-income investments can also provide a reassuring sense of "ballast" to a portfolio, since the original principal investment is returned at a later, pre-specified date. That said, the "real" value in terms of both principal preservation and the income stream lessens over time because inflation erodes the purchasing power of fixed-income investments.

Ibbotson data shows that inflation has averaged 3% per year since 1925, in a range of –1.3% to 7.3%. Thus, there are many years when cash and fixed-income investments have a tough time generating any real growth above inflation. Like a river eating away at a mountain base, inflation erodes your purchasing power year after year. If you expect your portfolio to cover your long-term living expenses and your legacy goals, you will need to build in strategies for portfolio growth that will beat inflation.

Stocks

An interest in a stock traded on the public markets represents an ownership stake in a public company. When you invest in stocks (equities), you are buying a stream of future earnings and possibly dividends; return to the shareholder comes in the form of share price appreciation and dividends. Ideally, companies with growing earnings will increase their dividend payouts over time—a second means by which this asset class can grow to outpace inflation over the long term. Shareholders are last in line in order of preference if the company declares bankruptcy, as creditors such as bank lenders and bond owners are in line ahead of shareholders.

Ibbotson lists the average long-term return of large cap U.S. stocks at 10.4%, within a standard range of –9.7% to 30.5%. Of the asset classes discussed so far, stocks obviously have the greatest potential for the highest return on investment—but also the greatest potential for short-term price variability. Why own stocks when the range of "normally expected" returns in any single period is so wide? Because stocks have historically provided the most reliable hedge against the ravages of inflation over long periods of time. (See line graph.)

On the bright side, time and diversification (across sectors, market capitalization, and global locations) can help to modify the interim ups and downs. The accompanying bar chart shows both the tightening of the range and the larger positive tilt of equity returns compared with U.S. Treasuries and Government Bonds over historic 10-year holding periods. A review of rolling holding periods from 1925 through 2005 shows that stocks have compounded at a rate between 5% and 15.8% in each 10-year period.

Step 2: Your basic needs, wants, and nice-to-haves

It is important for you to understand exactly what your portfolio must provide for—both now and in the future. Much as the USDA's food pyramid outlines optimal servings of the types of nutrients needed for a healthy lifestyle, your investment "pyramid" should outline how much of each of the various investment asset classes might be needed in your investment portfolio to ensure the cash flow that you will need over time. Think about dividing your pool of assets into buckets to provide:

• Basic living expenses
• Legacies (gifts during lifetime or after to children, charity, etc.)
• Lifestyle enhancements

The foundation of your pyramid must rest on the investment asset mix needed to produce the cash flow to sustain your lifestyle. The first steps are to identify how much you must accumulate for your core investment portfolio and the investment mix for the amount that will most likely produce the needed cash flow. For example, if you need $200,000 per year to sustain your current lifestyle (assuming that you have no other sources of income), your core portfolio should be more than $5 million, if you do not want to tap into your nest egg in a big way. Remember to figure in any large one-time cash expenditures you anticipate—the purchase of a second home, or the taxes due next spring on the proceeds from the sale of the business you just sold. Invest monies earmarked for these large short-term expenses conservatively—you do not want to risk losing the money that you will need soon. And remember to factor the long-term adverse effects of inflation into your thinking when you are reviewing asset allocation alternatives. Even if you are in your 60s or 70s, you will need to effectively double today's income at least once—perhaps twice—to keep pace with average inflation. Note that $100,000 of 1980 income bought less than $55,000 of goods in 2005, assuming average annual inflation of 3%.

Set target ranges for various asset classes, either in percentages or in dollar terms. Industry pundits think in terms of percentages (e.g., 60% equity/40% fixed), but over the years I have found that many clients find psychological comfort in having a specific, tangible dollar amount in a category such as U.S. Government Bonds "just in case." Once you have set your target ranges for various asset classes, you can run a back-of-the envelope weighted calculation to obtain a rough idea of the growth and cash flow that your portfolio can provide over time. Write down your goals, investment allocation ranges, and rationale, so that you can use them as a touchstone when markets are unruly. It is amazing how helpful it is to be able to remind yourself why you have the portfolio structure that you do when headlines are telling you to panic.

Once you have psychologically filled up the buckets to cover specific large expenses and short- to intermediate-term living expenses, you can think about how to invest your "left over" assets. Do you want to invest these in more aggressive categories (such as venture, emerging markets, etc.) in an attempt to grow them more rapidly for your heirs or for charitable purposes? Do you want to place a portion of these assets into an account where you can "try out" hot tips, angel investments, or other investments that you would not want to risk with the assets that must cover your day-to-day needs? Or do you prefer to do the opposite and invest more conservatively "just in case"?

If, on the other hand, you realize that you have larger spending and legacy goals than your portfolio can support, you will need to consider one (or both) of two options: scale back your goals or delay the point at which you begin to withdraw assets from your investment portfolio. Odd as it may seem, many people do not take the time to run a realistic assessment of investment assets versus spending goals in order to balance personal needs and wants against the withdrawals that a pool of investment assets can realistically support. Instead, they try to force the investment base to fit a certain lifestyle—often leading to a dangerous cycle of trying to reach for return by making investments that are riskier than may be prudent.

Finding the sweet spot between growth, income, and spending level for each portfolio is as unique as that portfolio's owner—and it is a sweet spot that by its nature changes over time as the owner's needs change over time. The exercise is well worth the effort, however, and will go a long way toward ensuring that your expectations and outcomes are as closely aligned as possible.

Carol M. Clark, CFA, is a partner and investment principal of Lowry Hill Private Wealth Management, a 20-year-old firm offering comprehensive investment and financial management services to more than 300 families from its offices in Minneapolis, Scottsdale, Ariz., and Naples, Fla. Prospective clients are willing to invest at least $10 million. She welcomes questions and comments at cclark@lowryhill.com.