Asset Allocation & Risk
 


Practical Application

Some people we may come into contact with believe we have to have years of financial training to become a smart investor and accumulate wealth. But in actuality, there are no major secrets to becoming a smart investor or accumulating wealth. If asked what the biggest secret of them all in accumulating wealth was, we would probably all have a different answer. We could say the biggest secret of accumulating wealth is to invest early or gaining knowledge or invest in good quality investment, or live within your means, or to maintain an emergency fund or even to invest often. For the individuals who are serious about their financial goals probably understand the sacrifice, discipline, common sense and consistency to accumulate wealth. We could even say that some of our co-workers really only understand one concept - that of the need to earn money. There is another concept that needs to be understood also. That concept is systematically saving and investing money.

There are many different types of people and their financial habits are equally unique. Some people could be classified as savers or "Scrooges." While others do not save anything and thus not prepared for emergencies. To become financially independent, it requires some investment knowledge and discipline.

It could be said that we practice asset allocation in our every day lives. Each month families around the globe allocate a portion of their current assets to mortgage and utility payments. Is there any reward? Yes. They get to maintain their residence. If they did not allocate their assets to these payments, they run the risk of loss of service and a foreclosure. We could consider mortgage and utility payments as essential. The rewards and risks or payments and nonpayment are clearly defined.

Investment contributions are discretionary allocations.

We have learned basic financial planning skills such as how bad credit cards are unless paid off monthly or that eating out consistently wastes money. These would be apart in consumer discretionary spending. These are all straightforward identifiable costs. Investment contributions are discretionary allocations. The primary difference is that investing and savings are a reallocation of assets, not an expense. The positive side is that the person keeps the asset as part of their net worth.

It is equally important to understand the difference between:

[    Required spending and discretionary spending

[    Short term and long term investing.

Our goal should be to identify our potential client's discretionary assets available for investing to meet long term objectives that would include retirement planning and wealth accumulation. Once we identify these, we could move onto the short term individual essential and discretionary spending to see if funds can be invested for long term results. Once these are determined, we can allocate them in the most efficient manner within their acceptable risk levels.

Asset Allocation

There are two main issues to address in asset allocation:

1.     What are the investor's overall asset allocation guidelines?

2.     What are the investor's current allocations?

Asset allocation and diversification should not be confused as the same thing. Asset allocation, as it relates to variable annuities, is a person's allocation of assets to three primary areas:

1.     Stocks,

2.     Bonds, and

3.     Cash.

No other investments will offer the characteristics a person needs for growth, income and liquidity like stock, bonds and cash can. This means that assets distributed in these three basic areas, increases the chances that the probability that a portion of a person's assets will be able to increase. Further asset increases (a higher, long term, total investment return) will be realized because of the lack of asset concentration in one investment classification. The investment assets when they are distributed in these basic areas will produce a more consistent return. It also accomplishes the reduction of risk because asset allocation spreads the risk over all categories. A person could invest in real estate, for instance, because it is an attractive investment. However, this investment lacks liquidity. It would probably be better to buy a piece of property that would be intended for use rather than make a passive real estate investment.

"Proper asset allocation is crucial to investing.

Without it, success is impossible."

- The Lump Sum Handbook by Anthony Gallea

A person's need for income can best be met with bonds and the need for growth by common stocks (equities). Cash, which in general has the lowest return, can be used to meet current income needs or because stock and bonds are unattractive.

Diversification, as it relates to variable annuities, is choosing the sub-accounts in the variable annuity contract. The individual sub-accounts are explained in the next chapter. The sub-account decisions are made after the stocks, bonds and cash percentages are determined.

For example, an investor could choose the following asset allocation example:

Then taking the 60% allocated to stocks (equities), the investor can then diversify by allocating:

We could then say that the significance is that 100 percent of the stock (equity) investment is 60 percent of the total portfolio.

It should also be stated that while the investor's selections are limited to sub-accounts, the selection of the individual securities remains with the sub-account managers.

Another approach to deciding on an overall asset allocation strategy, an investor could allot:

This would be then that an investor's common stock portfolio would never exceed 50 percent of their portfolio, nor comprise less than 25 percent. This would be the investor's overall asset allocation.

The next question to consider is whether the investor should be at 25 or 35 or 50 percent.

To arrive at an investor's overall allocation, they need to explore the expected returns for each asset class over time. A person can figure some likely returns over long periods of time and then apply the appropriate risk profile for each class of asset, helping to determine precisely how much risk is taken for the reward. Something else that needs to be considered is how each of the asset classes act in relationship to others. This gives some idea of best and worst case scenarios. Viewing historic returns also gives a framework in which to work.

Annual Returns for each Asset Class (covering 65 years):

Common Stocks

10.1%

Long-Term Bonds

4.6%

Cash (T-bills)

3.7%

Inflation

3.6%

Table information source: The Lump Sum Handbook by Anthony Gallea

With the above information in mind, it would be easy to say then that one should put 100 percent in stocks because that asset class offers the highest historic returns. For younger investors, with a longer time horizon, that may not be too far off the mark. However, the above chart only shows the returns on each asset class. One must also consider the risk that each investment has.

Why should so much importance be given to asset allocation?

The proper allocation of an investor's assets within a securities portfolio is considered by most expert money managers as the principal ingredient for successful investment performance of the assets. The proper allocation of investment assets, combined with specific investment selections, risk management and interpretation of economic and other market influences forms the basis for successful money management and a satisfied investor. In fact, investors should understand that asset allocation and diversification actually reduce, rather than increase, risk. It is important not to confuse the investment uses of these classes (stock, bonds and cash). It could be said that utility stocks can be used for income, confusing the line between stocks and bonds. However, a person needs to think of utility stocks as growth vehicles. If an investor begins to confuse growth and income, they will find themselves running higher degrees of risk than they assumed when they invested. Investors that have an on the dynamics of inflation and the need for risk reduction can serve themselves very well.

Basically, asset allocation is simply apportioning investment assets among various categories. The asset allocation determination is made without regard to specific stocks or bonds. The true test of asset allocation can be determined by the overall mix that, when combined with proper security selection within each asset category, meets the investor's needs within their acceptable risk-tolerance level. On the whole, most investors are conservative, risk adverse and are most comfortable with consistent returns. By placing an emphasis on proper asset allocation, it can generate more consistent returns and more predictable risk forecasts.

Investors should understand that asset allocation and

diversification can actually reduce risk, rather than increase it.

A person would be best served if they put their time into proper asset allocation. Quite a few investors spend their time trying to pick a good stock. However, Anthony Gallea in his book The Lump Sum Handbook states: "I think that's a mistake. It has been estimated that 80 percent of the price movement in an individual stock can be attributed to the overall movement of the stock market, and of the remaining 20 percent can be found in the movement of the specific industry.

"Yet most investors spend most of their time looking for individual stocks, rather then looking at the market as a whole. You should do the opposite. Don't be concerned with what stocks to buy as much as to whether you should be buying stocks at all."

How should an investor decide their asset allocation portfolio?

The need for proper asset allocation has been established. An in fact, it could be said that it is the most important investment decision to make. Deciding what asset class to own is an important aspect of the investment decision.

For an investor to decide on the specific asset allocation, they must first analyze their circumstances to establish a satisfactory model. The question an investor should ask themselves is: What asset allocation will produce the maximum return within my risk tolerance?

To help answer this question, an investor must explore the following:

1.     Overall Wealth: The more money an investor has or their net worth, the more tolerant they are to risk. An individual with a home and $50,000 in investment assets near retirement cannot tolerate the same risk as Bill Gates of Microsoft.

2.     Age: The younger an investor is, the longer their time horizon is for their investment to increase. This means they can afford the risk of the up-and- down market cycles to ride the long-term positive trend. The closer a person is to retirement, the more they cannot afford the risk of a wrong decision. They do not have the luxury of time to bail them out, so they must be more conservative.

3.     Current Income Needs: An investor's current income requirements need to be established versus the long term total return. With the advances of modern medical technology, our life spans are increasing. So it is not uncommon for a 60 year old to look forward to 20 to 25 years of investing. Because of the increased life spans, it may be considered a mistake to limit investments strictly to government and other high-quality bonds once an investor has reached 60 years of age. While the percentage of common stocks may be reduced, it should be eliminated only is cases when an investor's wealth overwhelms the need to maintain a good overall return.

4.     Goals: The goals of investors are basically the same: they all want to increase their money. A particular investor could be putting their money away specifically for their retirement or an investor could have "extra" money from a recent inheritance.

5.     Investment Experiences: An investor could have a bad taste in their mouth for certain types of investments that have faired very poorly for them in the past, thus they want to avoid them now. Or an investor could have had awesome experience with a certain investment and want to put all their eggs in one basket.

How often should an investor analyze their asset allocation model?

An asset allocation model should be analyzed every quarter or twice per year and readjust the allocation to account for the performance of the asset classes. For the investor that has enlisted the aid of the expert money managers, the process may be quite simple. By making a course correction on a regular basis, an investor can make the asset allocation process most effective because it changes with time and circumstances.

Is asset allocation all-encompassing?

On the contrary, assets allocation is not all encompassing. An investor's financial strategy must include a consideration of income, time horizon, capital appreciation, risk concerns and the interrelationships of each consequence within a total investment strategy.

For example, if an investors chooses a 100 percent fixed-income portfolio for a short term time horizon, this should be acceptable. However, if this same fixed-income portfolio were chosen for a long term time horizon, it would likely not meet their financial goals. The inflation rate may grow faster than the funds invested. The fixed-income portfolios do meet risk concerns that the investor may have, but it does not meet the investment objective of maximizing returns within an acceptable risk-tolerance level. An investor's portfolio can be designed to meet many financial variables. Using asset allocation to address an investor's objectives need not be complicated at all. Properly done, it should be as straightforward as designing basic portfolios using simple asset allocation alternatives.

Only when an investor measures the risk against the reward can they be comfortable with their asset allocation model.

Only when an investor measures the risk against the reward can they be comfortable with their asset allocation model. Not all investors will have the same assets allocated to each asset class. Each investor must construct a portfolio within the context of their risk tolerance. Once an investor has gauged their tolerance for risk, the balance falls nicely into place. For the layperson, it may be that they are entirely unfamiliar with the concept of estimating a portfolio's risk before they commit their funds. Expert advice must be sought out from professionals working in the field of financial planning and investments.

With proper groundwork, agents can lessen the burden of anxiety because the ground work has been established.

Risk & Return

It could be said that the concept of risk and reward is the cornerstone of the investing process. Investment decisions should not be made without considering both the risk and the reward. All investments involve an element of risk and an anticipated return. Risk should be measured and quantified to determine its compatibility with predetermined investment objectives.

What is risk?

Risk, as it relates to investments, is the exposure to the chance of loss. Specifically, it means to investors that risk is the probability of a loss in either the market value (the price decreases) or the income stream (dividends) or both. There are four basic risks that an investor should consider:

1.     Business risk,

2.     Market risk,

3.     Interest-rate risk, and

4.     Inflation (price) risk

Of the four listed above, three are important to understand when investing in sub-accounts.

     Business Risk

An investor's income can decline due to a number of reasons occurring naturally to the business environment. This is important to money managers when making individual securities investments. It is less important to investors who have hired money managers to analyze the risk of individual securities. It is important, however, for investors purchasing individual securities.

     Market Risk

The market value of a sub-account can vary substantially over short periods of time. Market risk lessens over time, and variable annuities are long term investments. However, declines in market prices obviously reduce an investment's value.

     Interest-Rate Risk

The value of fixed-income securities and interest rates can vary adversely. Interest rate fluctuations can severely affect bond values and certificate of deposit (CDs) rates. Rising interest rates cause falling bond prices. Fixed-income investment unit values decrease periods of sharply rising interest rates.

     Inflation Risk

This is the most powerful risk an investor faces. Purchasing power risk is the risk that an investment's value will be eroded through inflation. Inflation risk is a major threat to fixed-income investments, particularly certificates of deposit (CDs). An investor needs to understand how inflation affects investment markets. But an investor should not think of the current inflation rate as a goal to beat or even aiming at keeping up with inflation. No matter what the current inflation rate is, an investor will profit most with the same broad strategy that would work in a non-inflationary economy. Investments should be picked that have the best profit and risk considerations.

Protection Against Inflation

One can protect themselves against the risk of inflation by simply following three steps. These steps would include understanding inflation, alternatives and a balanced portfolio.

Inflation does not shower its affection on any one-investment field.

For an investor to understand what they are up against is the first step. Most people hopefully have a rough understanding of the workings of inflation (what causes it and how it affects various investments and areas of the economy in different ways) so that educated decisions can be made. Understanding inflation will help an investor distinguish between the investments that can reduce financial uncertainty and those that will only make an investor's problems worse.

A key point to remember is that inflation does not shower its affection on any one investment field. There is no simple inflation hedge that will show profit because of inflation. One of the worst consequences that inflation causes is the chaos it creates in the economy and in the investment world. Because of inflation, almost all investments go through extreme cycles of boom and bust.

An investor should be open to all

the investment possibilities available to them.

It has often been suggested that an investor fold in an inflation hedge. However, while gold has been an excellent long term investment in past years, it has not been an inflation hedge. The relationship between the price of gold and the inflation rate has been overstated at times. It should also be noted that the price of a true inflation hedge would not stop during a period of declining inflation rates, it would merely go up more slowly.

The stock market, the supposed inflation hedge of the 1960s, has already proven that it does not. The real estate market's boom of the late 1970s, which seemed to be providing an inflation hedge for many people suddenly turned sour in late 1979. Bottom line: No investment will profit from every stage of an inflationary cycle.

The second step is to become acquainted with the range of investment alternatives and techniques available to the investor. Investors who shy away from investments that have done poorly in the past, may need to reexamine these investments. Above all, an investor should be open to all the investment possibilities available to them. This may be an agent's toughest hurdle to overcome.

And the final step in avoiding the risk of inflation is to construct a portfolio so well balanced that an investor can forget about their investments. Hopefully then they can return to things in life and be confident that their investment is protected and they should profit no matter how inflation evolves and no matter how and when it comes to an end. A key consideration for an investor is that there be proper balance among several different investments. Variable annuities offer an investor different investments fields thus providing a portfolio that is balanced. During a time of inflation and high interest rates, tax deferral is more important for dollar investments than for any others, since high interest rates mean that dollar investments will be producing more taxable income. Thus a device for deferring taxes will be especially valuable if it can be used to shelter assets denominated in dollars.

Variable annuities have two inflation-proofing features:

1.     An interest rate that moves upward with open-market interest rates, and

2.     The tax deferral that allows the interest to compound without tax erosion.

Variable annuities also have two deflation-proofing features:

1.     Provides a way of holding dollars without a prohibitive loss of purchasing power, and

2.     A deflation could make the guaranteed minimum interest rate extremely valuable.

Understanding inflation, investment alternatives and how to acquire a balanced portfolio may be the most intimidating thing for an investor to overcome is this understanding. It is time consuming and difficult to understand at times. Variable annuities offer professional money managers to relieve this burden somewhat.

Measuring All the Risks

Professional money mangers seek the maximum return for a given level of risk, while also seeking the lowest risk for a given level of return. A rational investment strategy dictates that investment options be ranked according to risk. This means that risk should be measured and quantified.

Measuring some risks comes intuitively. Investors understand that an aggressive growth stock has more risk than that of a Treasury bill or that the chances of being hit by lightening are infinitely higher than winning a lottery. We could safely say that all investors understand obvious risks and their counterbalance, the reward opportunity.

Unfortunately, the differences of investment risk are not so clearly stated or defined. For instance, which is a better buy given their levels of risk and return: Aggressive Growth or European equities? An investor's decision is most often based on either asset allocation models or mutual fund and/or sub-account investing because of their choice of provisionally managed investments.

However the investor should understand that various variable annuity sub-accounts have different risk and reward scenarios. For instance, aggressive growth sub-accounts has a higher risk/reward scenario than an Utility sub-account (each sub-account will be explained in the next chapter). That being the case, how does an investor evaluate risk and reward as it relates to sub-account investing?

The investment industry has devised measurements for each. They are known as:

1.     Alpha (reward), and

2.     Beta (degree of risk).

Alpha is an investor's expected return for the level of risk assumed. Beta measures the quantified risk over a given time period. In each case there will be variance that is measured by the standard deviation. This anticipates the upside and downside potential at a given level of risk. By definition, standard deviation is the opportunity for gain versus the possibility of a loss at a given level of risk.

Standard deviation is the opportunity for gain versus

the possibility of a loss at a given level of risk.

Alpha is important when measuring and comparing sub-accounts and money manager performance. The performance should be measured over a specified period of time and it should be measured and compared to its peers and industry averages.

The beta coefficient is one method of measuring risk. It relates the volatility of an investment to the market as a whole. The market, or measurement index, has a beta of 1.00. A sub-account with a beta greater than one has more risk than the market portfolio because its return is more volatile than the market. A sub-account with a higher beta would usually be classified as a growth or aggressive growth sub-account. Sub-accounts with betas less than one are more defensive and are often balanced or investment-grade, fixed-income sub-accounts.

Beta risk is an important consideration for professional money managers and investors alike because of the effective use of diversification can reduce residual risk. Beta derivation is a straightforward concept. Most sub-account betas are accessible to investors through numerous industry research publications and ratings services.

Lifecycle Beta

Beta can also be a measure of risk for an investor's stage in the lifecycle and general attitude toward risk. There is no quantifiable measurement for either because both are subjective. Though, it does not take a genius to figure out that preservation of capital is more important to older investors, while growth is normally more important to younger investors.

It is important for insurance agents, financial planners or whomever is discussing an investment portfolio with a client that they give them a realistic evaluation of the worst-case scenario.

Living With Risk and Return

The concepts of risk and return have been analyzed as separate entities. Hopefully most investors, as well as the agents selling them, understand the positive correlation between risk and return. Increased risk should offer increased return. As does decreased risks mean decreased returns.

An investor may expect a safe return of five percent by purchasing risk-free investments such as short-term certificates of deposit. Increasing our expected return above five percent involves also increasing the investor's assumption of risk. The relationship between risk and reward differs between investors and with the ever changing business environment.

In Summary