What is asset allocation? It is a system of investment diversification into various investments that tend not to move in concert. Most commonly, this is seen as splitting your holdings between stocks and bonds because they often move in opposite directions. Allocation is not meant for considering just one stock and one bond as each one carries the risk of failure or success for a particular company. Rather, it is a general risk of one class of investment balanced against another. Stocks and bonds often move differently, gold will almost always go up in an inflationary environment while bonds will trend down under those circumstances. This is the logic of asset allocation. Gold and bonds are said to carry what is called an inverse relationship. That is, if one goes up, the other will go down, but not necessarily proportionately. If it is an absolute relation, one goes up one point while the other goes down one point. Most investments, however, have only the tendency to go opposite ways. The greater the probability of this inverse relationship, the more stable your portfolio will be. If you select a variety of diverse investments, then you are beginning an allocation. The goal of this topic then is to discuss ways of allocating or diversifying your portfolio. At the same time, it is meant to provide you with ideas that will help balance your portfolio in ways that will work to your advantage. Why is this concept of low volatility so important? Let’s look at the math in our first illustration.
Consistency matters A risk sensitive investment manager relies on a consistent approach to help produce consistent results. The goal? Helping their shareholders avoid scenarios like the one depicted in this table:
• An investment that gained 10% for three straight years would have an average annual total return of 10%. • But if , in the fourth year, the investment were to lose 10%, the average annual total return would drop to 4.6% • To get back to an average annual return of 10%, the fund would have to rise 34.4% in the fifth year - a return well in excess of market norms.	• The Arithmetic of Loss • 1-year return$$$ Average annual total return Year 1 10.0% 10.0% Year 2 10.0% 10.0% Year 3 10.0% 10.0% Year 4 -10.0% 4.6% Year 5 34.4% 10.0% * For illustration purposes only. Investor results will differ.
Applying dollar value to this illustration helps make the point. $1,000 at 10% for one year yields us a $1,100 year end value. $1,100 at 10% for year two yields us $1,210, year three end is $1,331. Down 10% year 4 closes the year at $1198. To maintain our 10% return through five years, we need to get to an ending value of $1,610. To achieve this, our year five return needs to be 34%. We want to do what we can to protect ourselves by keeping volatility to a minimum. We can help accomplish low volatility by diversifying into products which have a low correlation but we still need a reasonable rate of return. We could have all cash investments and therefore experience no volatility, but our deminimus or minimal return would cause us to be losing purchasing power through inflation. The chart below shows how bad that can be.
Worth of $1,000 after Inflation   Year 3% 4% 5% 6% 7%   5 859 815 774 734 696   10 737 665 556 539 484   15 633 542 463 395 337   20 544 442 358 290 234   25 467 360 277 213 163
When we examine how the big boys invest, we can see that unlike the average corporate pension fund, we are not likely to have our own company stock as part of the investment choices. Nor are we going to have a hedge fund if our income is less than $200,000 and our investable worth is less than a million. Without using a hedge fund and no company stock included, pension funds follow a plan that would be a good starting model for us to examine. How well do they do? On average, they generate a return of about 8%.
Eight percent is a very good return when compared to that of the average investor. Bad performance most often happens in a portfolio when an investor gets in and out at the wrong times. Warning! Do not try to time the market! Do not bet the ranch on a few hot stocks, especially all in the same sector. See the graph below:
AVERAGE ANNUAL TOTAL RETURNS 1984 - 2002
12.22%                                                                                                                                       3.14%         2.57%                                                                     Average Equity Investor   Inflation   S & P 500 Index
“Quantitative Analysis of Investor Behavior – Report, Dalbar, Inc. Past performance is not indicative of future results. Investor fees may not be reflected in the investor results.