Allocation

After the initial assessment meeting, the next step in the investment process is utilizing the information obtained to create a personal asset allocation model for the prospective client. Asset allocation is the process of balancing the risks of investing. Experienced investors have long known that focusing on investment return, without due consideration for risk, invites potentially excessive losses. Developing a successful asset allocation strategy requires the recognition of the following four principles:

• There are no risk free investments
• There are no perfect or best investments
• All investment decisions are compromises
• Successful investing requires patience and discipline over the long-term

At the outset, it is important to understand what the process of asset allocation can and cannot do for the investor. There are three primary determinants of an investor's return: the asset allocation process, the security selection (i.e., asset management) process and the timing of the investment purchases. Significant academic study of investment returns suggests that the asset allocation process is the single most important factor in determining how a diversified portfolio will perform over time. Therefore, careful consideration of asset allocation is advisable.

Long term, the asset allocation process enhances returns by helping to control risks. However, asset allocation is not a "get rich quick" strategy. In fact, it is a gradual process. Neither will the asset allocation process eliminate the risk of a short-term loss in a portfolio.

The investment professional will make an asset allocation recommendation only after a careful consideration of the prospective client's goals, time horizon and risk tolerance. A well thought out investment goal(s) is critical to intelligent investment decisions. Investment goals can range from funding a specific purchase, such as a home, to sending a child to college, to funding a retirement lifestyle, to maintaining a standard of living.

The investment time horizon is defined as the period of time between the present and the achievement of the stated goal. For example, an investor whose goal is to send a five-year-old child or grandchild to college has a time horizon of approximately 13 to 17 years. Often, time horizon can be an indefinite period of time. For example, a 55 year old couple planning to retire at 60 do not have a five-year time horizon, unless they do not plan to live beyond their first year of retirement. Rather, they have a potential time horizon of 30 years (based on current actuarial estimates) until the surviving spouse dies. A poor understanding of time horizon can result in the assumption of inappropriate investment risks.

Understanding the subject of risk tolerance requires an understanding of investment risk. Risk comes in many forms and no single investment is free of all forms of investment risk. Some individuals view risk only in terms of permanent loss of capital. Others might see risk as any decline in the value of an investment. Investment professionals tend to perceive the risks of investing as falling into one of two categories, unsystematic risk and systematic risk.

Unsystematic risk is comprised of two components, business risk and financial risk. Business risk is the possibility that the management of the company you have invested in will make poor decisions, which could temporarily or permanently impair the value of your investment. For example, a company that thought it was in the buggy whip business and not the transportation business fared poorly after the introduction of the automobile. Financial risk is the risk that an otherwise well run business could suffer a loss because it is poorly capitalized. For example, if a business takes on too much debt its investors may suffer losses due to excessive interest payments even though the business generates profits on its operations.

The process of diversification can help control unsystematic risk. Diversification means owning many different securities within a particular asset class. For example, diversification within a stock portfolio means not only owning more than one stock, but it means owning stocks in companies in several different industries. Owning 10 different companies all in the same industry does not achieve true diversification. One should keep in mind diversification does not guarantee a profit nor protect against a loss in a declining market.

Systematic risk is the risk inherent in the investment markets. Investors experience systematic risk in a stock portfolio when a stock they own declines in value due to deteriorating market conditions, even though the company issuing the stock may be posting robust results. Fixed income investors can experience systematic risk when, for example, interest rates rise causing the market value of their bond holdings to fall.

The process of asset allocation can help contol systematic risk. Broad classes of assets (stocks and fixed income, for example) do not necessarily move in lock step. Sometimes one asset class is going up while the other is going down. Even within asset classes, different sub-categories may respond in varying manners to similar market conditions (i.e., growth and value styles of stock investing, and long and short-term fixed income maturities). The asset allocation process blends different asset classes and asset subcategories together with the primary objective of dampening the fluctuations in an investor's return. Asset allocation should, long term (five years or more), minimize these risks of investing. Over the short term however, losses due to market fluctuations are possible. Keep in mind, asset allocation can not guarantee a profit.

Understanding how the asset allocation process can help control investment risk requires some understanding of basic asset classes. In our analysis we use two broad asset classes: stocks and fixed income. As discussed, within each category there may be many sub-categories. For example, there are short, intermediate and long-term maturity municipal, corporate and government fixed income investments. All asset classes are not appropriate for all clients under all circumstances.

Fixed income (including cash investments) are, essentially, loans. In any loan transaction the lender provides money in exchange for the borrower's promise to repay the loan with interest. Fixed income investments may also be called bonds, notes, debentures or similar names. Fixed income investments with very short maturity (like Treasury Bills or commercial paper) are thought of as cash alternatives. Fixed income investments are included in an asset allocation primarily to provide a reliable source of income. Historically, they have tended to have lower price fluctuations (or "volatility") than equity investments. Taken together, cash alternatives and fixed income investments may be thought of as the foundation on which a portfolio is constructed.

Stock investments are investments in the ownership of business entities or other assets. Stocks have provided the long-term growth of capital necessary to outstrip inflation over long periods of time. However, just as the stability of cash alternatives generally requires investors to accept lower returns, the historically higher growth rates of stocks requires the investor to accept fluctuations in the value of their investments.

Sound investment planning is a process, not an event. As such, a critical part of making asset allocation work properly is to review and revise the model as needed. A number of factors may necessitate changing a client's allocation. Goals may change. Their time horizon may also change. A client may discover that their risk tolerance, in fact, is different from that suggested by the information provided in the initial assessment meeting. In each instance, an adjustment may be required. Even if the fundamental assumptions made to produce an asset allocation model do not change, market conditions will change. Changing market conditions may dictate a re-balancing back to the original allocation.

It is through this process of reviewing and revising the client's asset allocation, as needed, that the investment professional will make the most progress toward achieving their financial goals.

Assessment | Allocation | Asset Management | Monitoring