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Asset allocation works in both bull and bear markets

In the pre-Internet era, way back when I first joined a 401(k) plan, my investment options were simply this: fixed fund, equity fund and bond fund. No further information was provided. The office manager who distributed the enrollment forms was rather cryptic, and my investment knowledge at the time was sketchy at best.

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"Equity fund. That's stocks, right?" I asked.
"Right," she said.
"Aren't stocks risky?"
"Yes," she said.
"What about bonds, are they risky?"
"Not as risky as stocks," she replied.

On a whim I decided to allocate half of my contributions to the equity fund and the rest into the bond fund. That was my initiation to the investment process.

In retrospect, if I'd had the proper guidance and education, I probably would have put more into the stock fund and much less into bonds.

Nowadays, most companies arm their employees with enough information to make reasonably intelligent investment decisions. For example, the 401(k) packet about my current plan, aside from weighing in at about two pounds, contains fairly weighty information. It includes an asset allocation quiz designed to help plan participants determine the proper mix for their investments.

Allocation, allocation, allocation
The importance of asset allocation cannot be overstated. It's similar to the importance of "location, location, location" as the top consideration when you buy real estate. In the 1980s, Gary Brinson, L. Randolph Hood and Gilbert Beebower determined that asset allocation explained more than 90 percent of the variability of returns in a portfolio. This finding unleashed great controversy among math geeks. Simply put, the successful combination of several asset classes helps reduce risk because of their low correlation to one another.

In fact, if you put together two investments that tend to go in opposite directions in different market situations, the combination has a stabilizing effect on your portfolio. This is true even if individually the investments are both "risky," meaning they can and do deviate substantially from their expected returns. Investment managers have spent much time in their quest for the best combination of asset classes that can produce the highest returns with the lowest levels of risk. They bandy about such terms as correlation coefficients, covariance, standard deviation and the like, and use complex algebraic expressions to support their hypotheses. (Yeah, but do they know how to have fun?)

How the smart money invests
Institutional money managers provide a glimpse of how to put an asset allocation plan in place. Many run pension plans for company or government employees and have the fiduciary responsibility of maximizing returns while managing risk, a balancing act that requires investment in various asset classes.

For example, the New York State and Local Retirement System breaks its investments down into 11 asset classes, but we'll simplify things here. Roughly 63 percent of their investment is in a mix of domestic and international stocks, 17 percent is in government bonds, 8 percent in corporate bonds, 2 percent in cash and the rest in an assortment of alternative and real-estate-related investments.

On the opposite coast, the California Public Employees' Retirement System has two thirds of its gargantuan $165 billion fund in stocks (with twice as much in domestic stocks than abroad), roughly 27 percent in global fixed-income investments and the rest in real estate. Less than 1 percent is in cash equivalents.

Notice that equities -- considered essential for growth -- represent the bulk of both funds, but that they also have a healthy bond component.

No one likes risk
"Investment is about risk and expected return," said Nobel Prize winner William F. Sharpe in a recent issue of Wealth Management magazine. "No one likes risk and the higher an investment's expected return, the better."

That said, it's important to try to gauge your level of risk tolerance before making an asset allocation decision. How would you feel if your 401(k) plan lost a bunch of money? Mind you, investments are supposed to increase in value, but some markets are difficult, as was the case recently.

If you had invested in the Vanguard 500 Index fund, which mirrors the Standard & Poor's 500, you would have lost 9.1 percent in 2000, been set back another 12 percent in 2001, and suffered a whopping 22.2 percent loss in 2002. A $10,000 investment would have dwindled to $6,223.38 by the end of those three years. Ouch!

Professionals vs. amateurs
So, if pitted against one another in a World Cup race of sorts, how would amateur investors like us perform compared to the pros?

Watson Wyatt Worldwide analyzed the rates of return for pension funds run by professional investment managers as well as 401(k) plans run by ordinary folks like us. The benefits consulting firm gleaned information from the regulatory filings of about 2,000 companies that offered both types of plans to their employees.

Remember -- pension fund managers have a mandate to invest prudently and so must diversify their holdings to reduce risk. We can do anything we want with our 401(k) portfolios, and often choose funds willy-nilly, with no asset allocation strategy whatsoever.

The results: The amateurs outmaneuvered pension fund investors from 1997 to 1999, during the bull run that immediately preceded the ugly bear market. 401(k) plans outperformed pension funds by roughly 1 percentage point in 1997, 2 points in 1998 and 5 points in 1999. With a higher allocation to stocks -- 80 percent to 90 percent -- 401(k) investors rode the bull market wave. In other words, a rising tide lifts all ships, and in good times, the rubber rafts we amateurs cobble together can bob right on top of the wave.

But then in the bear market that followed, we sunk, while sounder craft weathered the storm. Both types of investors posted negative returns, but pension funds fared better than 401(k) plans in the volatile period of January 2000 through December 2002. They outperformed the amateurs by 4.3 percentage points in 2000, 3.5 points in 2001, and nearly 4 points in 2002, according to the analysis. With their bond positions serving as ballast, pension funds were able to effectively minimize their losses.

Who wins when you look at the entire six years? The pros win handily, with an annualized return of 4.2 percent vs. 3.25 percent for the amateurs. This proves that not only is it important to pick funds that perform well when the wind is pushing the sails; it's also important to protect your portfolio with stabilizers in the event you hit a stock market storm.

Longtime financial journalist Barbara Mlotek Whelehan earned a certificate of specialization in financial planning.

If you have a comment or suggestion about this column, write to Boomer Bucks. If you have a particular financial problem that you would like addressed, please send your queries to Dr. Don, Tax Talk, the Real Estate Adviser or the Debt Adviser.


-- Posted: Feb. 9, 2005




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