January 2014: Asset Allocation

Welcome to 2014!  I hope your Holidays were fantastically fun and that you enjoyed a festive New Year.  I’m please to report that we had a wonderful Holiday season.  One of the things that made it so special was the birth of our second daughter: Rowan Marie McCann.  She arrived on November 17th – two weeks early.  She was actually due on Black Friday, the day after Thanksgiving.  I think she wanted to avoid the crowds.  Already a smart girl.  The whole family is doing wonderfully.

I thought this quarter would be a great time to follow on our last discussion regarding Reversion to the Mean.  Over the course of this year, we will re-balance our clients managed accounts.  So this is a great time to discuss some of the mechanics of managing your asset allocation…

Asset Allocation:  Fun with Pie Charts

When I talk about asset allocation, I’m referring to the percentage of each type of asset that you hold in your portfolio.  This could include US stocks, international stocks, corporate bonds, government bonds, commodities, real estate and a host of mundane and exotic asset classes on offer.  The way this is illustrated is usually with a candy colored pie chart like this one:

So what’s the big deal with asset allocation?  It works like this:

• Every year there will be a best performing asset
  
• We never know in advance what it will be (although lots of pundits and forecasters will give it a try)
  
• We would like to own the best performing assets, so we own all of the major asset classes so that we can be assured of getting our slice of the best return
  
• Every year, we rebalance.  Selling a little of what has done really well and buying some of what had done poorly
  
• In this way, we allow markets tendency to revert to the mean to work in our favor
  

To illustrate how this works, lets look at a much simpler allocation.  We’ll use a 60/40 allocation of US stocks and bonds:

During 2013, the stock market as measured by the S&P 500 returned +32%.  The bond market as measure by the Barclays Aggregate Bond index returned -2%.  If you started the year with the above allocation, then you would have ended the year with a bigger portfolio with 66.7% stocks and 33.3% bonds.  When you re-balance that portfolio back to your original allocation, you sell a portion of your stock that is larger than your target percentage (sell high) and buy bonds, which are lower than your target percentage (buy low).  In essence, every year you are forcing yourself to sell a small portion of what’s done well and buy a portion of what’s not done as well. 

So what’s the big deal with re-balancing, why not just let it ride? While we expect stocks to perform better over the long term, they are also significantly more volatile.  To explore this a little more, we need some simple statistics to describe our returns.  We generally talk about yearly returns for an asset in terms of its average return and its standard deviation.  The average represents the long-term average calculated on yearly basis.  The standard deviation represents the “swing” away from average that has been observed over time.  This represents the dispersion of results expected from a data series.  A picture is worth a thousand words, so here’s an illustration of average and standard deviation:

The average return for the S&P 500 has been 10.4% (1976-2012; source Wikipedia) but the standard deviation in returns has been a whopping 16.7%! Remember that -37% swing in 2008?  Most investors don’t want to experience that level of volatility.  So we add other assets, some of which have much lower volatility, like bonds.  For the same period bonds had an average return of 7.8% with a much lower standard deviation of 6.8%.

To illustrate the trade off of volatility (standard deviation) and returns (average) for a portfolio, let’s continue with our hypothetical two-asset portfolio of US stocks and bonds.  The following chart indicates the returns and standard deviation as we add increasingly higher percentages of bonds:

Source: S&P 500, Barclays US Aggregate Bond Index, 1976-2012, Wikipedia
Portfolio re-balance yearly to target allocation

As you can see, introducing even modest amounts of bonds into your allocation can dramatically lower the volatility of your portfolio.  For example, during 2008 a 100% stock portfolio lost 37% of its value.  A 70% stock 30% bond portfolio lost 24.3% of its value.  Adding bonds to your portfolio can add ballast that helps stabilize your returns during periods of volatility.  Additionally, adding other assets that react differently – even if they have high standard deviations – can help to further smooth your returns over time.  Since most investors don’t have the behavioral fortitude to deal with the full volatility of the markets, then adding additional assets to help reduce volatility becomes very important.

Of course, I’d be remiss if I didn’t point out that the return on bonds during the period analyzed (1976-2012) were particularly strong.  There is very little expectation that bond performance will be as strong in the short to medium term due to the rising interest rate environment we are experiencing (bond prices drop when interest rates rise).  However, bonds should remain less volatile than stocks and help stabilize your portfolio returns.

This was a very simplified analysis to illustrate the advantages of asset allocation and rebalancing.  We build robust portfolios for clients at Bootstrap Capital that are designed to address clients’ tolerance for risk and various market environments.  If you have any questions about asset allocation don’t hesitate to contact me.  Also, if your friends or family have questions about asset allocation or any financial issue, please feel free to make an introduction or forward this letter.  We provide Financial Planning and Investment Management services and we would be happy to talk with your acquaintances.  We will treat them with the same care and diligence that we treat you.

Take care,

Brian McCann, CFP®