David R. Evanson

Privately Published, Spring, 1995

History makes a strong case for allocating assets among the basic investment categories of stocks, bonds and cash. The key to successful investing however is knowing how much to invest in each of these basic categories and when. Consider the following:

Since 1925 stocks have, on average, returned about 10% to investors according to stock research firm Ibbotson Associates, Chicago. While this is a fairly spectacular performance, it comes with a price, since stocks present investors with the highest level of risk. For instance, over the same span of time, stocks lost 43% during their worst 1 year performance, and lost 0.89% during their worst 10 year performance.

Next there are bonds, also known as fixed income instruments. Since 1926, long term government bonds have returned, on average, about 5% to investors. Of course, bonds held to maturity are much safer than stocks. However, as the return shows, safety has its price.

And finally, there is cash. There is no risk to holding cash except loss of purchasing power. Since 1925, inflation has averaged about 3% annually. In a way however, some investors have made money with cash because holding onto it has kept them from losing substantial sums with bad investments. And cash equivalents, such as money market funds, have dramatically decreased the loss of purchasing power associated with inflation.

The Rubber Hits The Road
The crux of asset allocation among these categories is this: While no single kind of investment can meet all of your needs, you donzzt want to completely abandon what each one has to offer.

Someone who is 50 years old, and perhaps about to send a child to college might not want to risk their entire nest egg on stocks. But then again, with retirement or perhaps a wedding or another student on the horizon, this same investor would not want to completely give away the growth that stocks offer either.

Similarly, consider someone in their mid-to-late 30s. While they may require substantial growth in their holdings to reach their investment objectives, they may not want to completely ignore the safety offered by fixed income instruments.

The Flying Walendas
And so, a balance is required. This balance shifts over time and is a function of several factors including age, risk profile, investment objectives and an investorzzs total liquid net worth. And while there are several publications and investment services which provide precise percentage allocations for stocks, bonds and cash, depending on the outlook for each, here are a few general allocation guidelines.

For investors in their 20s and 30s, the allocation should be almost completely in stocks, with little or no allocation in fixed income, and enough cash to cover emergencies. People at this stage of their lives are generally working, have growing incomes and little need for cash or investment income. Thus these investors — risk profile willing — can weather the risk that stocks offer.

For investors in the middle bucket, 40 to 50 years old, needs frequently change, and as a result so too does the best allocation. At this point, people are beginning to see some cash needs. Educations, weddings, the purchase of a home, if they donzzt already have one. At the same time, retirement is looming larger, meaning that not only do investors have less time to finance retirement, but also less time to recover from risky investments that may deliver a loss. Accordingly, investors might shift the allocation to more cash and less stock so that they have near equal amounts of stocks and bonds.

And finally for investors in their 60s, or in retirement, it would seem as if the entire portfolio should be devoted to fixed income investments. But this is not so. To keep pace with inflation — that is to make sure the nest egg keeps growing so that it delivers an ever increasing income stream — some growth is needed as well. As a result, in this age bracket, investors need to keep the majority of their assets in fixed income investments and cash, with a small position in stocks.

Rocket Science
This is asset allocation at its most basic level. A more sophisticated approach, with a larger volume of assets involved would include real estate, precious metals, venture capital investments and even antiques and collectibles. This allocation would also make distinctions between small company stocks, and large company stocks, as well as international and domestic investments.

Mutual funds, incidentally, are not considered an asset class. A fund that invests in stocks would be part of a stock allocation, and a fund that invests in bonds, would be part of a bond allocation. In fact, because the investment criteria of mutual funds is so rigidly defined, they are an excellent vehicle with which to achieve asset allocation.

All investors should begin to allocate among stocks, bonds and cash after they have built their emergency cash fund, whether thatzzs just $5,000 or $25,000. While it is important to allocate as soon as practical, it is absolutely essential after an investorzzs financial assets total more than $200,000. Prior to $200,000 an investor allocating his or her assets among stocks, bonds and cash is really achieving diversification and minimizing risk. But after $200,000, asset allocation is really about increasing the overall return.

Achieving even a one or two point percentage return increase has a dramatic impact on the end result for investors. Consider this, from 1925 to 1994, a portfolio of government bonds returned 4.83% to investors. But a diversified portfolio consisting of stocks, bonds and cash returned 7.24%, a difference of 2.41%. What would this difference mean to an investor over 20 years who started with $200,000? A portfolio earning at 4.83% would grow to $513,738. A portfolio earning 7.24% through asset allocation would grow to $809,405, a whopping $295,000 difference. For $300,000 itzzs clearly worth an investorzzs time and energy to apply the principals of asset allocation to their investment portfolio.

————————————————————-

Now that you understand why and how to invest, be sure to read next month’s column next month which will explain how to find a broker to help you along the way.