E-160 8-02

DETERMINING THE APPROPRIATE ASSET ALLOCATION

Jason Johnson and Wade Polk*

Perhaps the most fundamental Stocks tend to earn more long- Time Horizon of all investment decisions relates term, but their value can fluctuate Your investment goals all have to asset allocation. Simply stated, significantly along the way. Bonds a time horizon, and that is an asset allocation is the selection of fall somewhere between the two in important consideration when investments from the various asset potential growth and safety. So determining appropriate invest- classes, which are generally cate- how should you allocate your ments. Your time horizon is the gorized as cash, hard assets, assets? number of years you have avail- stocks and bonds. Each asset class Investment Goals able to invest. It includes the time is affected by different circum- until you reach your goal, as well The first step is setting your stances and has values that do not as the period during which you investment goal. Some common move in the same direction at the make withdrawals from your investment goals are: to build suf- same time. The purpose of asset investment. For example, if you ficient assets for a comfortable allocation is to distribute your are saving for retirement, your retirement; to finance a child’s col- investments so that you achieve a time horizon should include not lege education; or to make a down level of return consistent with your only the time until you retire but payment on a home. If you have objectives and risk tolerance pro- also the years you plan to live off more than one goal in mind, you file. of retirement savings. Similarly, if might want to allocate assets It is estimated that more than you are saving for college, your specifically for each goal. Invest- 90 percent of the variation in time horizon should include the ment goals help you focus on why investment returns over time is a number of years until your child you’re investing and keep your result of asset allocation. So, deter- starts school, plus the years during plan on course when market mining the appropriate asset allo- which he or she will be enrolled. volatility tempts you to change cation is crucial to investment suc- The longer the time until you will your investment strategy. Your risk cess. For every investment goal need the money, the more time tolerance is your ability or willing- there is an asset allocation that you have to weather periodic (and ness to endure declines in the strikes a delicate balance between sometimes drastic) swings in the value of your investments while risk and reward. For example, market. Longer time horizons you wait for them to return a based on data compiled by allow you to select more aggres- profit that will help you meet your Ibbotson Associates through 1998, sive investments, assuming you investment goal. Consider how money market investments offer aren’t averse to risk. As time goes you would react to a 20 percent day-to-day stability but earn the by, your portfolio has less time to decline in the value of a stock smallest returns over long periods. recover from market dips, so you investment—a typical “bear mar- might choose to shift gradually to ket” occurrence. Over the past four a more conservative asset alloca- * Assistant Professor and Extension decades, bear markets have tion. Economist–Management and Extension occurred, on average, about once Program Specialist—Risk Management, every 5 years. The Texas A&M University System Liquidity of Investments

Less Collectibles Real Estate Gold Stocks Bonds CDs Money Market Cash More Liquid Funds Liquid

Figure 1. Relative liquidity of various investment options.

Liquidity Asset Classes Bonds are debt instruments. Liquidity refers to the ease with The typical asset classes are When you buy bonds you are basi- which an investment can be con- cash, hard assets, stocks and cally playing the role of a banker verted to cash. Financial planners bonds. Cash investments include and lending money to a corpora- generally recommend that you set money market accounts, certifi- tion or a government (local, state aside 3 to 6 months’ worth of liv- cates of deposit (CDs), and U.S. or federal). The bond issuer pays ing expenses (depending on the Treasury bills. you regular interest, and repays stability of your income) in a read- the initial investment at a future Hard assets include collectibles, ily accessible account for unfor- date. real estate and gold. The value of seen emergencies. These are liquid hard assets grows either with infla- Figure 2 presents a chart of assets. Different asset classes have tion or as the result of market options to help you evaluate the different levels of liquidity. (supply and demand) factors. The asset allocation choices. When Liquidity is less of a consideration value of hard assets can increase deciding how you will invest, con- for money invested to meet longer or decrease greatly; therefore, tim- sider all the factors mentioned pre- term goals. ing is important if they are to be viously. Then look at the expected effective investments. risk/reward tradeoff implied with Diversification different investment options by Diversification is a key compo- You can invest in the stocks of evaluating historical returns. nent of asset allocation. A diversi- either domestic or foreign compa- fied portfolio is one with a variety nies. Stock investments also can Historical Returns of the of asset classes that don’t tend to be categorized by the size of the Asset Classes rise or fall in value at the same companies (their market capital- Expected return is an estimate time. Spreading your investments ization). The terms large-, mid- of what the asset class will earn in across a variety of classes is and small-cap stocks refer to com- the future based on historical per- important because each type panies with a total market value of formance and economic projec- responds differently to market, more than $5 billion, between tions. As the adage goes, past per- inflation, interest-rate, currency $750 million and $5 billion, and formance is not a guarantee of and default risks. This moderates less than $750 million, respective- future results, but it can help you the effect of a poor performance ly. A growth stock is one issued by make educated decisions. If by any one asset class. For a company whose revenue is returns are volatile (vary widely instance, a strong economy may expected to grow more than the from year to year), an investment cause stock values to rise, but it average. Growth companies tend is considered high-risk. Table 1 could also bring rising interest to reinvest most of their earnings, shows the historical performance rates, which tends to cause bonds and therefore pay small dividends of various asset classes from 1926 to decline in value. On the other as the price of the stock increases. through 1997, as well as the per- hand, a stock may struggle in a A value stock is one issued by a cent of the time the classes have weak economy while bonds may company whose assets are consid- had positive returns. The inflation gain value because of falling inter- ered more important than the com- figures illustrate the risk of losing est rates. In short, investing in sev- pany’s long-term earning potential. purchasing power that all invest- eral asset classes can help you Income stocks usually denote ments face, especially those in benefit from changing economic mature companies with stable fixed-income assets. conditions while protecting you earnings and dividends. from adverse price swings. For further information: Ibbotson, Roger G. and Rex A. Sinquefield. Stocks, Bonds, Bills and Inflation Yearbook. Ibbotson Associates: Chicago, Illinois, 1998. Lummer, Scott L. and Mark W. Riepe. “The Role of Asset Allocation in Portfolio Management,” Global Asset Allocation: Techniques for Optimizing Portfolio Manage- ment. John Wiley & Sons: Toronto, 1994. Morris, Virginia B. and Kenneth M. Morris. A Woman’s Guide to Investing. Lightbulb Press: New York, 1998.

Figure 2. Investment options to choose among when making asset allocation decisions.

Table 1. Historical Returns of Major Asset Classes, 1926 -1997. Compound % Positive Asset class Best year Worst year annual return years Small Company Stocks 142.9% -58.0% 12.7% 71% Large Company Stocks 54.0% -43.3% 11.0% 72% Long-Term Corporate Bonds 42.6% - 8.1% 5.7% 78% Long-Term Government Bonds 40.4% - 9.2% 5.2% 72% U.S. Treasury Bills 14.7% 0.0% 3.8% 99% Inflation 18.2% -10.3% 3.1% 86%