Services
News
Taking a Look at Asset Allocation
– June 30, 2009
Establishing your "asset allocation" usually involves deciding how much of your investment pool of money (retirement plan, personal investments, etc.) you should invest in:
Cash (including CDs)
Fixed income (short, mid or long-term)
Equities (many sub categories to choose from)
Businesses obtain capital to grow primarily by borrowing the money (fixed income bonds or other loans) and/or getting others to invest as owners (equity capital). There are many variations/types of debt and equity capital.
In trying to decide on asset allocation, the first question one must usually ask is "How much risk should I take?"
Take a look at the Callan Periodic Table of Investment Returns 1989-2008. This table shows the yearly performance over a 20 year period of seven stock (equity) indices and one bond (fixed income) index. The first note to the Table makes a very important and widely accepted point . . . "above all, the Table shows that the case for diversification across investment styles (growth vs. value), capitalization (large vs. small) and equity markets (U.S. vs. International) is strong."
Note the riskiness of equity securities. Such risk must not be missed nor misunderstood when deciding on your allocation to equities. Observe all the negative returns in the years 2000, 2001, 2002 and 2008. If you had a large percent allocated to equities during the last ten years, the negative returns in those four years probably did serious damage to your bucket of money. Average return on the equity indices was a negative 17.60% for those four years.
Now, look at the BC Agg Bond Index for those same four years. Do you see a single negative return? No! Matter of fact, the average return on the BC Agg Bond Index for those four years was 8.9%.
Question: If you could redo your allocation for those four years, how much would you allocate to equities? I know, not a fair question. There are lots of actions we would like to "redo." The point is very simple. Equities are risky . . . ALL of them.
We are told you must invest in equities to protect against inflation. Really? I believe the above 8.9% return on the bond index beat the inflation rate. Furthermore, the average return on that index was 7.55% for the 20 year period shown on the Callan table and was 5.7% for the last ten years (assuming I did the math correctly).
So how much should I allocate to equities . . . 40%, 50%, 70%, 80%, or just use the "100 less my age" doctrine? If age is 40, invest 60% in equities. So how much? There is no correct answer to the question. Do you like the tortoise (who would probably allocate less to equities) or do you like the hare (who would probably allocate more to equities)? Who won?
One other point and I will summarize. The other point is "don't forget compounding." Systematic investing means adding to the bucket every month. That means live on less than you make and save/invest the difference . . . and do it every year. With all that has happened in the stock (equity) market in the last year, I believe many have forgotten the power of compounding. Richard Russell said "when I taught my kids about money, the first thing I taught them was the use of the ‘money bible.' What's the money bible? Simple, it's a volume of the compounding interest tables. Compounding is the royal road to riches. Compounding is the safe road, the sure road, and fortunately anybody can do it. To compound successfully you need the following: perseverance in order to keep you firmly on the savings path. You need intelligence in order to understand what you are doing and why. You need knowledge of the mathematical tables in order to comprehend the amazing rewards that will come to you if you faithfully follow the compounding road. And, of course, you need time, time to allow the power of compounding to work for you. Remember, compounding only works through time."
To summarize and conclude, I suggest the following:
- Diversify in both the fixed income and equity markets.
- Don't over-allocate (whatever that means to you) to equities.
- When rebalancing your portfolio, carefully consider the current financial and economic environment. There may be a good reason(s) for increasing or decreasing your allocation to equities.
- Don't forget the power of compounding. You want your portfolio to grow because of good returns and because you add to it on a regular basis.
I like the tortoise. His is a "slow ride" but the result can be nice.
Spencer Bernard, CPA, CFE
318.429.2044
sbernard@hmvcpa.com
Spencer is a partner in the audit department at Heard, McElroy & Vestal. He has been with the firm for over 35 years as evident in his vast amount of knowledge pertaining to audit and advisory services. In addition to being a certified public accountant, Spencer holds the designation of Certified Fraud Examiner (CFE).