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With the dawning of the new year, now is the time to take “stock” of your investment portfolio and determine if it is appropriately designed to fit your goals and risk tolerance. History has shown that the asset allocation decisions you make today will be the single greatest determinant for investment success, accounting for an astronomical 91.5% in the variation of your plan’s performance. It plays a far greater role on the growth of your portfolio than market timing or which specific stocks and bonds are chosen.
The need to diversify.
Common sense, as well as an age-old saying, warn not to put all your money in one place. You want an investment that will be safe, yet provide lucrative returns. While there are many asset categories to choose from and countless choices within each class, how do you choose where to invest?
The risk-reward relationship.
As you’re probably aware, the lower the risk or volatility, the smaller the potential return. If you decide to pursue larger returns, you must be willing to accept greater volatility. Obviously, no loss is desirable, but a carefully constructed portfolio using the time-tested techniques of modern portfolio theory and a thorough assessment of your needs and expectations, can over a long period of time, bring the desired return with reasonable measured risk.
Surprisingly, very few investors are aware of just how volatile their current portfolio really is (though 1998 went a long way in providing a good idea!) They freely accept advice on a product-by-product basis using a “shotgun” approach to their portfolio’s investment. Would you build a house without a detailed and carefully thought-out blueprint? Of course not. Yet the majority of investors proceed without the benefit of a written investment plan.
A prudent alternative.
The art of proper asset allocation is generally accomplished by performing a historical evaluation, such as shown in Chart One, prepared by Portfolio Management Consultants of Denver, Colorado. This chart documents the performance of stocks, bonds and cash over the past seventy-one years, including average returns and the largest one-year gains and losses.
While this chart may give an example of the extremes encountered over the last 71 years, it doesn’t tell a lot about what to expect under more typical conditions. In any given five-year period, based on historical data of the S&P 500, no one could reasonably expect $10,000 to increase (on average) to $15,302. However, there is about a 70% chance that the range of returns will vary from $11,500 to $18,000. This wide range creates the uncertainty that we define as risk. It is therefore rational to decide on your allocation by considering the time frame by which you might need this money, and your emotional ability to withstand this uncertainty.
Adding bonds to the portfolio will reduce the uncertainty, but will also reduce the potential return. The probable five-year growth of a portfolio derived from one-half S&P 500 type stocks and one-half immediate term government bonds would be $13,549; however, the range could be $12,500 to $15,000. Notice the narrower range. This leads to less risk and more predictable returns.
To get some idea of the value of time and how it reduces risk, the ten-year growth of the 100% stock portfolio mentioned above could grow to $23,414 within a range of $15,000 to $29,000, while the 50/50 portfolio could grow to $18,178 within a range of $14,000 to $22,000. One can see in both cases that the probability of a loss is very low.
Other important ways to reduce or increase the risk of a portfolio is to add different types of asset classes to your portfolio mix. For example, stocks of smaller companies generally will have greater volatility than stocks from larger companies. Stocks from developed international economies will be less risky than stocks from undeveloped or emerging economies. Corporate bonds are more volatile than similarly maturing government bonds, but will pay a higher return to compensate.
What’s the bottom line?
Invest extra time now and re-evaluate your current asset allocation strategy. There are good internet sites available that have simple, easy-to-use allocation calculators that can give you a good starting point to evaluate the risk to your portfolio. In addition, speak to your professional advisor about these issues. He or she should have more sophisticated tools to help you.
The keys to success are:
- Understand what you own.
- Understand your time horizon.
- Set realistic goals.
The ultimate rewards of good financial health and well-being are, after all, clearly worth the effort.