Asset Allocation

Posted April 2014 – John Spitzer & Todd Houge

For your investing, we think you should generally think of using four major asset classes. In this section, we take a quick look at cash equivalents (or cash, for short), bonds and CDs, stocks, and real estate. We also discuss the importance of your time horizon in using these assets. There are other classes, such as commodities (in particular, gold) and collectibles (art, antiques, autos, rare coins), but most financial advisors recommend that you focus on those first four major classes.

For planning purposes, the most significant differences among these classes are their characteristics for risk and expected return. As you’ve probably heard, risk and return are closely related – high returns are associated with high risk and low risk are associated with low returns. But please remember, the operative word is expected – high risk is associated with high expected return, so you can’t be assured that a higher risk investment will actually outperform a lower risk investment.

Cash Equivalents

Investments in cash equivalents (money market accounts, savings accounts, Treasury bills, etc.) have very low risk, and offer relatively low returns. The returns for these investments are close to the inflation rate, averaging about 3% per year over the past 80 years. Looking forward, we expect that the real return on these investments (the return adjusted for inflation) will be essentially zero, so don’t expect the money invested in these instruments to grow very much, relative to inflation.

Bonds and CDs

These securities offer a somewhat higher return, but also carry some risk. The average return on Treasury bonds over the past 80 years has been about 5% per year, or about 2 percentage points above the average rate of inflation. Most bonds entail a small to moderate degree of risk. Corporate bonds have the risk of default. Even a Treasury bond entails some risk if you sell it before maturity, because the value of bonds declines if interest rates increase.

Stocks

Investments in stocks have high risk, but have provided the highest historical average return. Over the past 85 years, stock returns have averaged about 10% per year on a compound basis, or about 7% in real terms. Going into 2008, many of the financial gurus opined that the stock market has become somewhat less risky compared with past decades, and they forecast that future returns to stocks will be lower – with real returns in the 4-6% range. This lower range is useful for projection purposes, although the events of the past decade cast doubt on the premise that stocks have become less risky.

The variation in returns from stocks is high, as evidenced by the events of during and since the dot-com bubble. For our favorite illustration of how much variation there is in stock returns, consider how many of the years since 1928 have recorded a return between zero and 20% (within about 10 percentage points of the average). What do you think – most of the years? About half of the years? Wrong – only 31 of the 86 years. Most of the time, in 64% of the years, the return was either negative or exceeded 20%. Interestingly, the corresponding percentages for 1994-2013 are similar – the return was negative or over 20% in 12 of the 20 years, or 60% of the time.

Real Estate

The risk and return characteristics of real estate are similar to those of the stock market. It is somewhat difficult to determine the historical average returns to real estate. They appear to be at the same general level as the returns to stocks, but slightly lower. Real estate also entails a considerable degree of risk – witness how real estate values rocketed and then crashed in 2008.

Time Horizon

In fitting these different asset classes into your financial planning, start with a question: when will you need the money?

If your time horizon is short – less than 2 years – invest in cash equivalents. The risks associated with stocks and real estate (and the transaction costs in real estate) are prohibitive for such a short time period, and bonds don’t give you enough greater return over a short period to bother.

For an intermediate time horizon, bonds or CDs represent a good choice. But be sure to match the maturity of the security with your time horizon.

If you won’t need the money for a long time, you can invest in stocks and real estate. Technically, you don’t have to invest in these other classes, but most of us can’t reach our objectives without the higher expected return that goes with these higher risk investments. You can reduce the risk of holding stocks by mixing in bonds, but you will also lower the expected return.

Now, what constitutes a long time? We’re OK with 5-7 years, but we really like 10 or more years. After the plunge of 2008, which brought 10-year stock returns to the zero level, we really like 10 years. This guidance is particularly relevant to you if you plan to retire within 10 years, and plan to convert funds into an annuity at that time. Those funds should not be in stocks or real estate.

As a final note, it is important to recognize that while the principle is clear – invest in high-risk investments only if your time horizon for the funds is long – it is not easy to follow it. The siren call of higher returns is hard to resist. You can calculate the difference in your holdings if the return is higher, while you can’t easily quantify the higher level of risk that those investments entail. Even the professionals often violate this principle. Our advice: be prepared to fight those temptations, stay disciplined, remember that your objective is “don’t be poor in retirement” and not “maximize your wealth.”