At Seabridge, we feel that asset allocation is one of the most important decisions a manager can make with regards to an investment portfolio because the asset allocation explains most of the risk and return. In fact, there are studies that conclude that asset allocation explains 90% of the variance of returns in an investment portfolio¹. It is not the selection of individual stocks or bonds driving performance, it is the asset allocation that makes the difference in the long-term.
To address this important point, we looked at a study that measured the results are from a performance analysis of stock and bonds returns from 1970 – 2010. ² As demonstrated below, when adding stocks to a portfolio of cash and fixed income, the resulting asset allocation can increase the return for a given level of risk or lower the risk for a given return:
Proper diversification across the appropriate asset classes is critical to building an investment portfolio for our clients. Market conditions that cause one asset class to do well often cause another asset class to have average or poor returns. Given that, we feel that most of our clients should be invested in the following U.S. and global asset classes:
- Equities (stocks)
- Fixed Income (bonds)
- REITs (real estate investment trusts)
- Commodities & Thematic Investments (where appropriate)
The percentage allocation across these asset classes will vary considerably depending upon the financial goals and risk tolerance of each client. For example, a conservative client unwilling to risk his or her principal would be mostly invested in highly-rated, short-duration fixed income securities. Another client willing to tolerate a great deal of fluctuation in the value of his or her portfolio in order to achieve higher returns will be invested mostly in equities (stocks).
Generally speaking, most clients will fall into one of the following five asset allocation models. Depending upon each client’s financial goals and risk tolerance, these asset allocation models may need to be adjusted to better reflect an individual client’s needs:
This portfolio is for those investors whose primary objectives are capital preservation and income. These investors are only typically willing to tolerate very minor price fluctuations in their investment portfolio. This portfolio is invested mostly in short/intermediate-term fixed income investments (bonds), in possible combination with income producing equities (preferred stock and REITs). A small portion of this portfolio may be invested in equities (stocks) as protection against inflation given that inflation erodes the purchasing power of fixed income investments.
This portfolio is for those investors who prefer balanced mix of capital preservation, income and capital appreciation. These investors are typically willing to tolerate minor price fluctuations in their investment portfolio, fluctuations that are normally associated with small amounts of equity (stock). The investments in this type portfolio are balanced among equities, fixed income (bonds), REITs and other asset classes.
This portfolio is for those investors whose primary objective is capital appreciation and to whom income is a secondary objective. These investors are typically willing to tolerate moderate price fluctuations in their investment portfolio. The assets in this portfolio are balanced but typically have a higher weighting of equities than fixed income as well as a moderate allocation of alternative investments and commodities & thematic asset classes.
This portfolio is for those investors whose primary goal is long-term capital appreciation. Generating income is not a goal. These investors are typically willing to tolerate potentially large price fluctuations. The assets in this portfolio are primarily invested in equities and could have a meaningful allocation of alternative investments and commodities & thematic asset classes.
This portfolio is for those investors whose primary goal is long-term capital appreciation. Generating income is not a goal. These investors are very aggressive and are typically willing to tolerate substantial price fluctuations in their investment portfolio. The assets in this portfolio are invested mostly in equities and may have a significant allocation of alternative investments and commodities & thematic asset classes.
¹ Source: Gary Brinson, L. Randolph Hood and Gilbert Beebower (1986) analyzed the returns of 91 large U.S. pension plans between 1974 and 1983. They concluded that asset allocation explained 90% of the variance in returns. That conclusion was confirmed by the same authors in 1991 after analyzing a larger database of returns. Roger Ibbotson and Paul Kaplan published a landmark study in 2001 titled "Does Asset Allocation Policy Explain 40%, 90%, or 100% of Performance?” The report confirmed that more than 90% of the variation in portfolio return is explained by asset allocation decisions.
² Source: Morningstar, Inc., 2011 Morningstar ETF Conference, presentation on Strategic Asset Allocation. Analysis of performance history of stocks and bonds over the period 1970- 2010. Risk and return are measured by standard deviation and compound annual return, respectively