Asset Allocation Theory

Modern portfolio theory is based on the concept of "efficient markets." In an efficient market information about securities is so wide spread and so well analyzed that it is extremely difficult to "beat the market" by knowing just when to buy or sell individual securities based on information or analysis that no one else has. The focus of modern portfolio managers has shifted from individual securities to the portfolio as a whole. The goal is not to get a hot tip on a blockbuster stock, but to construct a well-balanced portfolio that will allow the holder to achieve a desired return while reducing risk as much as possible. To do this, portfolio managers use the principles of Asset Allocation which will be discussed in further detail in this lesson. Historical Risk/Return of Asset Classes The major classes of liquid investments are normally divided into three main categories: stocks, bonds, and cash. Each of these asset classes has its own typical pattern of historical risk and return. Let's take a look at these patterns now. This graph shows how much $1 invested in 1925 in indices of small cap stocks, large cap stocks, government bonds, and cash (T-bills) would have been worth by 1997. In addition, it shows the inflation-adjusted value of $1 over the same time period. (The table does not account for transaction costs or taxes and assumes reinvestment of all dividends and interest.) Small cap stocks versus large cap stocks Small cap stocks had an average annual return of 12% over this time period, for a final value of $5,520. Large cap stocks grew at a slightly slower rate than did small caps -- 11% per year-- but that small difference over time resulted in a much lower final value of $1,828. Government bonds versus T-bills The $1 investment in government bonds returned an average of 5.2% per year, for a final value of $39, and $1 in cash (as represented by T-bills) grew only 3.8% per year, for a final value of $14. When you consider that $1, growing at the rate of inflation (3.1%) over this time period had a final value of $9, you can see that the holder of T-bills over this 72 year period earned a grand total of $5 adjusted for inflation! Small cap market risks Based on this data, one might conclude that the wise investor should place all of his or her money in small cap stocks, or at least in some sort of equities. But let's look more closely at the risks involved. In 1932, the small cap market as a whole returned 140%, but just four years later, in 1936, it lost almost 60% of its value. In fact, as you look at this graph, you can see that regular losses of 10% - 20% are not at all unusual in the small cap market. Annual Returns of Long-Term Government Bonds By contrast, look at the total annual returns of long-term government bonds. These rarely lose value, and in the few years in which they have, the loss has never exceeded 10%. Range of Returns So what is the "right" investment? This graph shows the range of returns if you had invested in various asset classes for one, five, or twenty year holding periods from 1926 to 1997. Clearly, if you had invested in the equity market as a whole for any twenty-year period during this time you could have easily weathered the volatility - the ups and downs - of equities and enjoyed a very significant reward. More Details This graph shows average returns in various asset classes for one, five, and twenty year holding periods from 1926 to 1997. [For example, 1926 to 1946 would be the first twenty year holding period. 1927 to 1947 would be the next twenty year period, 1928 to 1948 would be the next. And so on.] As you can see on the chart, the average return in the small cap market for one-year holding periods was 12.7%. However, the range of returns was as great as 140% or as low as -60%. The average return for all twenty-year holding periods was also 12. 7%. But the range of returns for twenty-year periods only varied from a high of 15% to a low of 9%. Thus the average volatility was enormously greater for one-year holding periods than for twenty-year holding periods. Returns and Holding Periods On the other hand - if the longest time period you have to invest is five years and you cannot take the risk of having less money at the end of five years than you had when you started (the money is being held in trust for a minor or will be used to pay off a debt), then government bonds and even T-bills become the prudent investment. So the "right" investment depends on your time horizon (how long before you need the money) and risk tolerance (ability to withstand losses in the portfolio). More Details As this chart shows, the return on small cap stocks for any five-year period between 1926 and 1997 was as great as 40% per year or as low as -25% per year. By contrast, the government bond market during any such five-year period never lost more than about 5% per year and T-bills never lost money at all. Of course, government bonds and cash didn't make much money either!