Modern Portfolio Theory - Let's just call it Asset Allocation

In past 25 years, we have come to frame the simple logic of diversification in terms of rigorous statistical model developed by finance academics: Modern Portfolio Theory.  In its most comprehensive form, modern portfolio theory dictates that portfolio composition should include all liquid asset classes – not only US stocks, bonds and cash reserves but also international investments, short positions, foreign exchange and precious metal from financial market place.  Theoretically it might sound feasible but lets not try to complicate our lives.

For  nearly all investors, the principal asset classes of choice boil down to common stocks (for maximum total return), bonds (for reasonable income), and cash reserves (for stability of principal). Each differs in risk: stocks are the most volatile, bonds are less so, and the nominal value of cash reserves is inviolable. In fact I would suggest short term bonds as superior alternative to cash reserves or money market funds.

Why do we need Asset Allocation?

My guidelines are simple: as a crude starting point two thirds in stocks, one- third in bonds. Balance optimizes returns from stock market in order to reach investment goals such as the accumulation of assets for retirement, but it holds the risk of loss to tolerable levels by ownership of some bonds too.

The entire act of balancing and diversification revolves around risk mitigation. But what is risk - Risk, in turn, is defined in terms of short-term fluctuations in expected value. Risk is something far more difficult to quantify. It relates to hoe much you can afford to lose without excessive damage to your pocketbook or your psyche.

Following table offers some historical perspective on the frequency and severity of loss that investors with various allocations to stock and bonds have suffered since 1926.

Stock/Bond Allocation%	Number of Years with a Loss	Average        One-Year  Loss (%)	Three-Year Loss (%) 1930-32	Two-Year Loss (%) 1973-74	Two-Year Loss (%)  2008-2009
100/0	24	-13.6	-60.9	-37.3	-25
80/20	23	-10.7	-45.6	-29.2	-20
60/40	19	-8.2	-30.2	-21.1	-15
40/60	17	-5.5	-14.9	-13.0	-10
20/80	15	-3.6	+0.5	-4.9	-5

But does the above table suggest that bonds are better investments than stocks? Some who were completed invested in bonds during 1973 crash might argue but let’s look at the history.  For the long-term investor, however, it would have been tragic to do so. For in the 23 years that followed, stocks provided an annual return of 16.6 percent, compared to just 10 percent for bonds. A portfolio that began with just a 40 percent bond/60 percent stock allocation and was left untouched would have enjoyed a return of 14.6 percent. Bonds are best used as a source of regular income and as a moderating influence on stock portfolio, not as an alternative to stock. Remember, the goal of the long-term investor is not to preserve capital in the short run, but to earn real, inflation-adjusted, long-term losses.

So, the greatest benefit of a balanced investment program is that it makes risk more palatable. An allocation to bonds moderates the short-term volatility of stocks, giving the risk-average long-term investor the courage and confidence to sustain a heavy allocation to exquisites. Choose a balance of stocks and bonds according to your unique circumstances-your investment objectives, your time horizon, your level of comfort with risk, and your financial resources.

Striking Your Own Balance

How can you determine an appropriate balance of your own needs? Let’s look at the matrix to understand basics of asset allocation. The matrix assumes that the over long time periods the stocks outperform bonds and the stocks are more volatile than bonds.

The main points of the matrix are based on common sense. During the accumulation phase of your personal cycle, when you are building assets, you are putting aside money that you would otherwise spend. (It’s never easy, but always essential.) You invest your capital, and you reinvest your dividends and your capital gains distributions. Because you have no immediate need for these assets, you can put your capital at greater risk in pursuit of higher return. As a younger investor, you might allocate as much as 80 percent or more of your portfolio to stocks, with the remainder in bonds. As the later years of your accumulation phase begin, you are older and have less time to recoup any decline in the value of your portfolio. At that point, you might limit your stock exposure to no more than 70 percent.

During the distribution phase of your investment cycle- when you enjoy the fruits of the accumulation phase-you depend on a relatively fixes pool of capital t generate income for your needs. You are withdrawing the income generated by your investments, and you cannot afford substantial short term loss. At the start of the distribution phase, you might reduce your stock allocation to 60 percent or so. As you age you might want to cut it to 50 percent.

It would be imprudent for a highly risk-tolerant young investor (25 years old or so), who is just beginning to invest for retirement, to allocate everything to stocks, provided that the investor had confidence that regular investments could be made through thick and thin. In the distribution phase, a highly risk-averse older investor who has substantial means could cut the stock allocation to as low as 30 percent.

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