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Global asset allocation for individual investors.

In advising PFP clients on investment strategies, the first and most important decision is the investment asset mix. The author explains the factors to be considered and provides a method for determining the proper mix. Also printed are some reasons why investing overseas makes sense and a simplified approach to investing using these strategies.

Asset allocation is the process of distributing portfolio investments among the various available asset categories--money market instruments, bonds, stocks, real estate, precious metals and other assets. Three broad techniques for asset allocation are generally recognized. Strategic asset allocation focuses on long-range policy decisions to determine the appropriate normal asset mix. Tactical asset allocation changes the mix based on market predictions to exploit superior market predictions through such techniques as sector rotation or market timing. Dynamic asset allocation reacts to changing market conditions by making relatively frequent changes in the asset mix with the goal of combining downside protection with upside participation. Tactical asset allocation and dynamic asset allocation techniques normally are employed within the context of overall investment policy set by strategic asset allocation; they amount to variations on the theme laid out by strategic asset allocation.

For a diversified portfolio, selection of the investment asset mix--the strategic asset allocation decision--is the single most important determinant of long-term investment performance. In a widely quoted study which originally appeared in the July/August 1986 issue of the Financial Analysts Journal, Brinson, Hood, and Beebower devised a means to test the performance contribution of three activities in the investment management process: investment policy (asset allocation), market timing, and security selection. They found investment policy dominates market timing and security selection, explaining 94% of the variation in total return for 91 large U.S. pension plans. In short, the impact of the allocation of capital among asset classes totally overwhelms the impact of what particular securities the investor owns within each asset class. In a diversified portfolio, for example, the selection of specific stocks to hold within the equity portion of the portfolio will have much less impact on total performance than will the decision of what percentage of the portfolio will be allocated to equity investments relative to other asset classes.

Asset Allocation Assumptions

The strategic asset allocation approach proposed here is based on three intuitively appealing and generally accepted assumptions. First, it is assumed that risk and return go hand-in-hand in the capital markets: the only way to increase long-run return is to move out on the risk spectrum. In terms of standard deviation of return, the higher the standard deviation of return, the riskier the investment.

The second assumption is that the capital markets are reasonably efficient over the long run and that future return spreads will be similar to historical spreads, at least in direction if not exactly in magnitude. The absolute amount of future spreads obviously will vary but one can be reasonably confident, for example, that bonds will offer higher returns than money market instruments and stocks will offer higher returns than bonds.

Finally, it is assumed market timing is not likely to enhance long-term investment results. This assumption is supported by a wealth of empirical data.

Strategic Asset Allocation

The logical implication of these three assumptions is that any asset allocation model should take a long-term, strategic approach to asset allocation and any resulting portfolio should offer broad diversification among asset classes. An asset allocation system must be a function of an investor's return needs, including consideration of income and capital growth, and risk tolerance, including risk aversion, loss aversion, and liquidity preference. Risk aversion is the classical hypothesized behavior of the "rational economic person" faced with making a decision involving risk. The rational economic person is assumed to make investment choices that maximize expected return at any given risk level or, alternately and equivalently, minimize risk at any given return level.

Modern portfolio theory assumes investors base their portfolio decisions on only two considerations: the expected return on an investment and its riskiness as measured by the standard deviation of expected return. For individual investors, however, risk is a far more complex issue than simple standard deviation of return. Research has shown that individuals do not necessarily exhibit risk averse behavior under all circumstances. In fact, individuals faced with the probability of a loss often seek to minimize the probability of losing money rather than seeking to maximize expected return. A wealth of practical experience also has shown that many investors' primary concern is loss avoidance rather than maximizing expected return for a given level of standard deviation. In addition to concerns with minimizing the probability of losing money (loss aversion), individual investors also are concerned with controlling liquidity risk. Liquidity risk may be defined as the risk of not being able to liquidate an investment promptly or at a reasonable cost. Real estate and limited partnerships are especially vulnerable to liquidity risk. However, liquidity risk extends even to securities investments such as stocks and bonds that trade in highly liquid markets (i.e., have more than adequate market liquidity) but might have to be sold in a down market if liquidation is necessary to meet some financial emergency.

In counseling individual investors, it is often useful to assess their risk tolerance before addressing return objectives. The most important point for them to understand is that there really is no such thing as a "risk free investment." In planning an investment portfolio, investors do not have a choice of "risky" versus "risk-free" investments. Even if they choose to leave their funds in the bank or invest all of their money in Treasury bills, they will face serious purchasing power risks since these types of investments generally fail to keep pace with inflation on an after-tax return basis. Such "risk-free" options virtually guarantee loss of purchasing power of investment capital over time. A key part of the investment asset allocation process is to decide what types of risk the client is willing to accept and the amount of each type of risk. The overall objective of asset allocation should be to earn the highest possible long-run return available from investments compatible with the investor's risk tolerance and income and liquidity needs.

Asset Categories for Individual Investors

The asset allocation model proposed here focuses on five generic categories of investment assets: money market instruments, U.S. bonds, international (non-U.S.) bonds, U.S. common stocks, and international (non-U.S.) common stocks. These asset categories are selected because reliable long-term risk and return statistics are available and because they reflect the asset categories most readily available to individual investors. The U.S. stocks category also may include real estate in the form of real estate investment trusts (REITs). Alternately, where other real estate investments such as limited partnerships or direct investment may be appropriate, real estate allocations may be substituted for U.S. common stocks.

The exclusion of investment assets such as precious metals, futures, options, and managed commodity pools is not meant to imply these investment categories may not be highly appropriate for a particular client. The approach taken here is conceptual in nature and is only meant to provide an overall framework for asset allocation. Substitutions for some of the recommended asset categories may be highly appropriate in consideration of individual client circumstances and investment objectives.

The five generic categories of investments offer differing types of investment risk/return tradeoffs and meet different investor needs and objectives. Money market instruments offer a very high degree of safety of principal and immediate liquidity along with a rate of return commensurate with inflation. As noted, however, money market investments are subject to maximum purchasing power risk. Longer-term fixed income investments, such as U.S. and international bonds, offer a high degree of current yield, reasonable liquidity, and, for investment grade bonds, excellent protection of principal if held to maturity. In addition, long-term bonds offer an effective hedge against deflation because bond prices increase when interest rates decrease during periods of economic adversity. Of course, on the downside, bond prices fall during periods of rising interest rates, exposing investors to interest rate risk. During the 1978-81 period, for example, high interest rates forced bond values down to the extent total returns (capital change plus interest earnings) were negative for all four years. Bonds subsequently staged a spectacular recovery during 1982, returning over 40% as interest rates fell. The interest rate adjustments by the Federal Reserve earlier this year have had a powerful negative impact on bond prices.

Equity investments, such as U.S. and international common stocks, offer the best opportunity for long-term capital gains but also are generally the riskiest investments from the perspective of potential for loss and fluctuation in principal values. These investments are the classic hedges against inflation as they generally increase in value over long periods of time as the economy expands. Total returns fluctuate the most for equities, and, based on past experience, equity investors must be prepared for the near certainty there will be years in which their equity investments will decline in value. In fact, historical data show that although common stocks provide the highest long-run rates of return overall, they lose money about one-third of the time. Equity investors must be financially and psychologically prepared for this event.

International (Non-U.S.) bonds and stocks are identified as a separate asset class in the asset allocation model. International securities are strongly recommended for inclusion in investors' portfolios for three reasons: 1) the size of the international markets relative to U.S. markets, 2) higher returns that have historically been available in the international markets, and 3) the diversification benefits of international investment. According to estimates provided by Brinson Partners, Inc. of Chicago, in terms of size, as of the end of 1993, the world investable capital market totaled approximately $33.7 trillion, including the world supply of cash equivalents, U.S. and international stocks and bonds, and U.S. real estate. Of this total, approximately $16.7 trillion is in the form of bonds, with U.S. bonds accounting for approximately 46% of the total bond market. On the equity side, U.S. and international stocks amount to approximately $12.5 trillion, with U.S. stocks accounting for approximately 43% of the total. Thus, over half of the world investable capital market lies outside the United States. Simple common sense would dictate the search for an optimal investment portfolio should not be restricted to less than half of the available securities. It makes no more sense for U.S. investors to invest in only U.S. securities than it would make for California pension managers to only invest in companies headquartered in California.

Historical returns on non-U.S. markets have been very attractive. Exhibit 1 illustrates the case for the equity markets (bond market advantages are similar but complicated by the decision of whether to hedge foreign currency exposure; this issue is beyond the scope of this discussion). The exhibit shows the average annual compound rate of return on U.S. stocks (measured by the S&P 500 Index) compared to international stocks (measured by the EAFE Index, an index of stocks in Europe, Australia, and the Far East developed by Morgan Stanley) for all overlapping 10-year holding periods from 1982 through 1992. In all eleven of these 10-year periods, non-U.S. equities achieved higher average annual compound rates of return than U.S. equities. They also had higher standard deviations of return (i.e., higher risk) in all 11 periods. However, because of the low correlation of returns with U.S. markets, international equities offer important diversification benefits.

The correlation coefficient measures the degree to which the returns on two assets moved together. If they move in lock step, they are said to be perfectly positively correlated; their correlation coefficient is + 1.0. If they move exactly the opposite of each other, their correlation is -1.0. If there is no relationship at all, the correlation is 0.0. The "magic of diversification" is that if assets with low correlations are grouped together in portfolios, the overall variability of the portfolio is reduced.

Consider an extreme case where two assets both have an average annual return of 10%, an annual standard deviation of 20%, and a correlation of -1.0. A correlation of -1.0 means the returns on the two assets are exactly the opposite of each other. Both average 10% per year in return, but when one is up the other is down and vice versa. If the two assets are combined in a portfolio in equal amounts, the portfolio would average 100/o per year but have a standard deviation of zero. The two individual assets would have up years and down years, but the two taken together would earn 10% every year. Of course, perfect negative correlation does not happen in the real world, but asset classes do have correlations of less than one and are sometimes even negative.

The international markets, particularly emerging markets, offer the best opportunities for investments that have low correlations of return with U.S. markets. Exhibit 1 reports the square of the correlation coefficient referred to in investment terminology as the "R-square" of a portfolio. The R-square statistic measures the degree to which U.S. and international markets move together: the R-square of .32 for the ten years ending with 1992, for example, indicates that 32% of the return on one index is explained by its co-movement with the other index. Since 68% of the return on one index is independent of the other, combining the two of them offers significant diversification benefits. In fact, several private and published studies have shown the diversification benefits of adding international stocks to a U.S. portfolio actually increases return while decreasing standard deviation. This phenomenon occurs up to the point at which approximately 30 to 40% of a solely U.S. portfolio is diversified into non-U.S. stocks, after which point risk and return increase together. Based on these types of observations, a number of studies have concluded that 30 to 40% international exposure is an optimal international exposure for a U.S. investor.

Global Portfolio Asset Allocation Scoring System (Global Pass)

Exhibit 2 presents a Global Portfolio Allocation Scoring System (PASS) for determining an appropriate portfolio asset allocation guide for individual investors. This PASS system is designed to provide a rough outline of an action strategy for an individual investor.


The PASS system requires investors to score themselves on a 1-to-5 scale on seven important return and risk objectives. All seven objectives are scored on a one-to-five scale; the more points scored, the more the portfolio will be oriented toward equity investments. Conversely, a low score would orient the portfolio more toward fixed-income investments. The PASS system is essentially a kind of "aggressiveness index" in that the more aggressive one's return objectives and the higher one's risk tolerance, the more points scored on PASS. The higher the PASS score, the more the portfolio should be oriented toward equities and away from money market and fixed income investments. The PASS system will point out to investors and their advisors that to earn higher returns investors must accept higher risk, and one way to mitigate these higher risks is to diversify.

All of the questions on PASS are structured such that a response of "strongly agree" results in a score of five points and a response "strongly disagree" results in a score of one point. A "neutral" response yields three points. The first three questions measure return objectives. Strong agreement with the need to earn high long-term returns that will allow capital to grow faster than the inflation rate results in a score of five points. If this objective is not important to an investor and he or she strongly disagrees with the statement, this question would receive a score of one point. The second question deals with the opportunity to defer taxation on capital gains and/or interest to later years. These opportunities generally are associated with equity-type investments. The third question assesses the extent to which the portfolio is required to generate current income. The less the current income requirement, the more aggressive the portfolio can be.

The last four investment objectives--dealing with time horizon, total return fluctuation, the probability of realizing a loss in some years, and liquidity needs--measure four different aspects of an investor's risk tolerance. The more tolerant an investor is of these different aspects of risk the higher is the PASS score and the more the portfolio should be oriented to equities.

To use PASS, investors simply circle the number under the column that most closely describes the importance of each investment objective to their personal investment objectives. The total value of all the numbers circled are added and the score is then used to determine the investor's diversification guidelines, given in the lower section.

At one extreme, a PASS score of 35 will result if the investor strongly agrees with all of the return and risk statements on the form. A PASS score of 35 translates into a portfolio consisting of five percent money market instruments, 100/o U.S. bonds, five percent international bonds, 50% U.S. equities and 30% international equities. Keep in mind that, where appropriate, U.S. equities may include real estate and other equity-type investments.

At the other extreme, the lowest possible PASS score of seven would result if the investor strongly disagrees with all of the investment return and risk objectives. A score of seven translates into a portfolio allocation of 10% in money market instruments, 40% in U.S. bonds, 20% in international bonds, 20 % in U.S. equities, and 100/o in international equities. A PASS score between the extremes of 35 and 7 results in a gradual modification of portfolio allocation.

Obviously, the PASS system provides only a rough guideline for portfolio allocation. It is not meant to be a fail-safe mechanical system to solve all of an individual investor's planning needs. The PASS score, however, does provide a very useful "blunt instrument" for turning investment objectives and personal risk tolerance into an action strategy. The system also forces investors and their advisors to explicitly recognize the existence of the investment risk/return trade-off process and come to grips with their own risk/return preferences and income needs. Based on the author's experience in investment counseling and management, the best use of the Global PASS Model is as a starting point to force discussion with clients about their investment needs and to provide an overall conceptual basis for designing a customized portfolio. An investment advisor using PASS may need to modify the scoring guidelines to fit the individual needs of a particular client.

Historical Return and Risk

Historical return and risk data are useful to illustrate the risk/return implications of asset allocation decisions. Exhibit 3 shows the average annual compound rate of return and growth of a $100 investment for the post-World War 11 period (1946-93) and for the years since 1970 (1970-1993) for consumer prices, Treasury bills, corporate bonds, and U.S. common stocks. The growth of a $100 investment is shown as a cumulative wealth index. This number just shows what an investment of $100 would have grown to if left invested at the compound rate of return shown for the particular investment series. A $100 investment in U.S. common stocks, for example, made at the beginning of 1946 would have grown to $20,256 by the end of 1993.


The data for the post-world War II period and the more recent period show that the risk/return trade-off in the financial markets does in fact exist over long periods of time. As one progresses from the most secure investments in Treasury bills to the most risky investments in common stocks, the return earned increases. Over the 1946-93 period, common stocks provided an average annual compound rate of return nearly two and one-half times that of Treasury bills. Stocks, of course are riskier. The long-term standard deviation of stock returns is over six times greater than Treasury bills. This risk/return trade-off relationship has also held up in more recent years: over the 1970-93 period, for example, common stocks earned an average annual compound rate of return of approximately 11.4% per year compared to 10.0% for corporate bonds and 7.1% for T-bills. Inflation averaged 5.8% over this period.

Implementing Asset Allocation Decisions with No-Load Mutual Funds

One cost effective method to implement asset allocation is through the use of no-load mutual funds. No-load mutual funds provide three major advantages that are difficult for individual investors to achieve. First, mutual funds are broadly diversified among securities, offering individual investors the opportunity to spread the risk of securities investing by buying shares in broadly diversified portfolios. A related advantage is the fact brokerage commission rates paid by large portfolios such as mutual funds are very small compared to the rates paid by individuals.

The second major advantage of mutual funds is they provide professional management at a relatively low cost. Total expense ratios for equity mutual funds, including management fees, generally run in the neighborhood of 1.0 to 1.2% of the dollar value of a fun's assets (bond funds are lower). For no-load funds, the third advantage of mutual fund investing is that no-load funds do not charge a commission on funds invested. If investors or their advisors are willing to undertake their own independent research, a portfolio of no-load funds can be constructed that offers an extremely low cost method of diversifying investment holdings.

Exhibits 4 and 5 show two hypothetical portfolios that correspond to two of the Global PASS allocation recommendations. All of the funds are no-load funds that have been selected based on successful track records; these funds are shown only to illustrate the risk/reward tradeoffs available from some "real" funds currently available to individual investors. Neither exhibit is intended to comprise a list of recommended funds for any particular investor. Both exhibits use exactly the same funds with the asset allocation changed to illustrate the difference between total returns and cash yields of the most aggressive allocation of the Global PASS Model (800/o equities) and the least aggressive allocation of the Global PASS Model (30% equities).


Exhibit 4 is the most aggressive portfolio, consisting of the following allocation: five percent money market instruments (returns are approximated as equal to the returns on Treasury bills), 10% U.S. bonds, five percent international bonds, 50% U.S. stocks, and 30% international stock funds. Actual return and yield statistics are taken from the Morningstar Mutual Funds service. Over the 1989-93 period, this portfolio would have earned an average annual compound rate of return of 13.80/o per year. As of the end of March 1994, the approximate cash yield on the portfolio would have been 2.4%. Thus a hypothetical portfolio of $1,000,000 would yield an annual cash flow of approximately $24,000 in 1994. Of course, past returns are no guarantee of future returns, so whether this portfolio would be likely to earn an annual return of 13.8%. in the future is unknown.

The portfolio in Exhibit 5 is the most conservative of the Global PASS portfolios. It contains exactly the same funds as in Exhibit 4, but the allocation has been changed to 10% in T-bills, 40% in U.S. bond funds, 20% in international bond funds, 200% in U.S. stock funds, and 100% in international stock funds. Financial theory and practical experience would suggest that the more conservative allocation, with more bonds and less stocks, would offer a higher cash yield and would have earned a lower total return. In fact, this does turn out to be the case: the more conservative portfolio provides a cash yield of approximately 4.9% and would have earned a total return of 12.1% per year over the 1989-93 period.

Only a Starting Point

The approach to asset allocation suggested here and illustrated with the two hypothetical portfolios can be used to help guide investors through the investment planning process. The Global PASS Model incorporates return, income, and liquidity needs along with the major aspects of risk aversion and loss aversion that govern planning for individual clients. The approach is mainly conceptual in nature--the Global PASS Model is intended to offer a starting point for meaningful discussions with clients, not an end point.


          U.S. Equities       Non-U.S. Equities

10 Years
 Ending   Return  Std.Dev.  Return  Std.Dev  R2

1982        6.7     18.6      7.0     19.7   .53

1983       10.6     18.2      1.1     18.4    .58

1984       14.7     15.6     14.8     17.6    .41

1985       14.3     14.0     16.4     15.3    .28

1986       13.7     14.4     22.3     17.4    .28

1987       15.2     17.0     22.9     18.9    .39

1988       16.2     16.5     22.4     19.4    .38

1989       17.4     16.6     22.9     19.6    .34

1990       13.8     17.1     17.2     21.9    .39

1991       17.5     16.8     18.8     21.3    .34

1992       16.0     15.7     17.4     21.0    .32

Source: Frank Russell Company, Tacoma, Washington.
Reprinted with permission.

William G. Droms, DBA, CFA,is the John J. Powers, Jr. Professor of Finance, School of Business, Georgetown University.
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Title Annotation:High-Net-Worth Planning: The Perilous Climb
Author:Droms, William G.
Publication:The CPA Journal
Date:Sep 1, 1994
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