In their well-known textbook, Investments, Zvi Bodie, Alex Kane, and Alan Marcus define asset allocation as "the distribution of risky investments across broad asset classes." Taking a broader view, asset allocation can be defined as the process of investing assets in a manner reflecting one's unique ability, willingness, and need to take risk. Consider these as three different tests.
An investor's ability to take risk is determined by four factors: (1) investment horizon, (2) stability of earned income, (3) need for liquidity, and (4) options that can be exercised should there be a need for "Plan B."
Let's begin with the issue of the investment horizon. The longer the horizon, the greater is the ability to wait out the virtually inevitable bear markets. In addition, the longer the investment horizon, the more likely equities will provide higher returns than fixed-income investments.
Table 3.1 provides a guideline for this part of the ability to take risk.
Investment horizon is not the only consideration: The individual's labor capital must be considered. This asset is often overlooked because it does not appear on any balance sheet.
An investor's ability to take risk is impacted by the stability of their earned income. The greater the stability of earned income, the greater the ability to take the risks of equity ownership. For example, a tenured professor has a greater ability to take risk than either a worker in a highly cyclical industry where layoffs are common or an entrepreneur owning a business with cyclical earnings. The tenured professor's earned income has bond-like characteristics. All other things being equal, she has more ability to hold equity investments. The entrepreneur's earned income has equity-like characteristics. He should hold more fixed income investments.
Table 3.1. Ability to Take Risk
Investment Horizon | Maximum Equity Allocation (%) |
|---|---|
0–3 years | 0 |
4 years | 10 |
5 years | 20 |
6 years | 30 |
7 years | 40 |
8 years | 50 |
9 years | 60 |
10 years | 70 |
11–14 years | 80 |
15–19 years | 90 |
20 years or longer | 100 |
For some investors, particularly those with high net worth or approaching retirement, labor capital may be a very small part of their overall wealth. For such investors, labor capital considerations should have less impact on the asset allocation decision.
A third factor impacting the ability to take risk is the need for liquidity. The need for liquidity is determined by the amount of near-term cash requirements as well as the potential for unanticipated calls on capital. The liquidity test begins by determining the amount of cash reserve one requires to meet unanticipated needs for cash, such as medical bills, car or home repair, or job loss. Financial planners generally recommend a cash reserve of about six months of ordinary expenses.
The fourth factor impacting the ability to take risk is the presence (or absence) of options one can exercise should a severe bear market create the risk the investment plan will fail. As we discussed in the section on the need for a Plan B, options include delaying retirement, taking a part-time job, downsizing the current home, selling a second home, lowering consumption, or moving to a region with a lower cost of living. The more options, the more risk one can take.
The willingness to take risk is determined by the "stomach acid" test. Ask yourself this question: Do you have the fortitude and discipline to stick with your predetermined investment strategy when the going gets rough? To a large degree, successful investment management depends on the investor's abilities to withstand periods of stress and overcome the severe emotional hurdles present during bear markets like the ones experienced in 1973–74, 2000–02, and 2008–09.
Table 3.2 provides a guideline for investors to test their willingness to take risk.
The need to take risk is determined by the rate of return required to achieve the investor's financial objectives. The greater the rate of return needed to achieve one's financial objective, the more equity (and/or small and value) risk one needs to take. A critical part of the process is differentiating between real needs and desires. These are very personal decisions with no right answers. The fewer things falling into the needs column, the lower the need to take risk. Conversely, the more things fall into the needs column, the more risk one will have to take to meet the need. Therefore, in considering the financial objective, carefully consider what economists call the marginal utility of wealth: how much any potential incremental wealth is worth relative to the risk that must be accepted in order to achieve a greater expected return. While more money is always better than less, at some point most people achieve a lifestyle with which they are very comfortable. At that point, taking on incremental risk to achieve a higher net worth no longer makes sense: The potential damage of an unexpected negative outcome far exceeds any benefit gained from incremental wealth. Put another way: "The inconvenience of going from rich to poor is greater than most people can tolerate. Staying rich requires an entirely different approach from getting rich. It might be said that one gets rich by working hard and taking big risks, and that one stays rich by limiting risk and not spending too much."[2]
Each investor needs to decide at what level of wealth their unique utility of wealth curve starts flattening out and begins bending sharply to the right. Beyond this point, there is little reason to take incremental risk to achieve a higher expected return. Many wealthy investors have experienced devastating losses that could easily have been avoided if they had had the wisdom to know what author Joseph Heller knew. Kurt Vonnegut told this story about his fellow author:
"Heller and I were at a party given by a billionaire on Shelter Island. I said, 'Joe, how does it make you feel to know that our host only yesterday may have made more money than your novel Catch-22 has earned in its entire history?' Joe said, 'I've got something he can never have.' And I said, 'What on earth could that be, Joe?' And Joe said, 'The knowledge that I've got enough.'"
The lesson about knowing when enough is enough can be learned from the following incident. In March 2003, Larry was in Rochester, Minnesota, for a seminar based on his book, Rational Investing in Irrational Times: How to Avoid the Costly Mistakes Even Smart People Make. During his visit, he met with a seventy-one-year-old couple with financial assets of $3 million. Three years earlier, their portfolio had been worth $13 million. The only way they could have experienced that kind of loss was if they had held a portfolio that was almost all equities and heavily concentrated in U.S. large-cap growth stocks, especially technology stocks. They confirmed this. They told Larry that they had been working with a financial adviser during this period—demonstrating that while good advice does not have to be expensive, bad advice almost always costs you dearly.
Larry asked the couple if, instead of their portfolio falling almost 80 percent, doubling it to $26 million would have led to any meaningful change in the quality of their lives. The response was a definitive no. Larry commented that the experience of watching $13 million shrink to $3 million must have been very painful and that they probably had spent many sleepless nights. They confirmed his observation. He then asked why they had taken the risks they did, knowing that the potential benefit was not going to change their lives very much but that a negative outcome like the one they had experienced would be so painful. The wife turned to the husband and punched him, exclaiming, "I told you so!" Some risks are not worth taking. Prudent investors do not take more risk than they have the ability, willingness, or need to take. Think about it this way: If you've already won the game, why still play?
When analyses of your ability, willingness, and need to take risk all lead to the same conclusion, the asset allocation decision is easy. However, there are often conflicts. For example, one can have a high ability and willingness to take risk but little need. In that case, the answer is simple: Because the marginal utility of wealth is likely low, the need to take risk should dominate the decision. Sometimes the choices are more difficult. Consider the following situation.
Philip is an extremely nervous investor. His willingness to take risk would probably produce an equity allocation approaching zero. He knows, however, that a very low equity allocation is apt to produce very little, if any, growth in the real value of his portfolio. This directly conflicts with his personal objective to retire within ten to fifteen years. To attain this objective, Philip knows he must take more risk, so chooses an equity allocation of at least 80 percent. The lower the equity allocation, the longer he would have to continue in the workforce. His willingness to take risk proved to be in direct conflict with his personal goals. Larry told Philip there was no correct answer to this conundrum. He would have to choose which of his objectives would have greater priority—the need to sleep well or the desire for early retirement. Ultimately, Philip decided his early retirement objective should take priority. He realized this decision was apt to produce those sleepless nights and that his ability and willingness to stay the course might be sorely tested.
Choosing the higher equity allocation (taking more risk) was the right choice for Philip, but it might not be the right choice for you. In general, we recommend choosing the lowest equity allocation derived from the three tests and then altering your goals. For example, if you find you have a higher need to take risk than your ability or willingness suggests, your plan should use the lower equity allocation recommended by the ability and willingness to take risks. Otherwise, if the risks show up—in the form of bear markets or negative events such as divorce or job loss—the plan will fail, and you may not be able to successfully adapt to the change in circumstances. The alternative is to lower your goal and save more now and/or plan on working longer. As discussed earlier, the more options one has, the more risk one can take. Having said that, before taking a higher level of risk, make sure you are truly willing to exercise those options. While it may be possible to move to a lower cost of living area, if your spouse doesn't want to leave the grandchildren, it won't happen.
The tables provided in this chapter are useful tools, good starting points for deliberations on the asset allocation decision, but many other factors influence that decision. The following sections provide application examples to help you make the appropriate recommendation. Use of a Monte Carlo simulator, explained in Chapter 16, is also recommended for determining your asset allocation.
The fundamental concept of risk and return in equity investing is embodied in what is known as the Fama-French three-factor model, named after professors Eugene F. Fama and Kenneth R. French. The model states that the returns one can expect from a diversified equity portfolio are virtually unrelated to either the ability to pick stocks or timing the market. Instead, it is the degree of exposure to three risk factors that explains the majority of returns.
The first risk factor is the portfolio's exposure to the overall stock market. Since equities are riskier than fixed-income investments, they must provide higher expected returns. Note that when discussing risk premiums financial economists use annual (arithmetic mean), not annualized (compound) returns. From 1927 through 2008, the average annual equity risk premium—the return above riskless one-month Treasury bills—has been 7.5 percent.
The second risk factor is the size of a company as determined by market capitalization. Intuitively, we know that small companies are riskier than large companies. They have provided an annual risk premium of 3.0 percent over large companies.
The third risk factor considers "value." High book-to-market (BtM) value stocks are intuitively riskier than low BtM growth stocks. They have provided an annual risk premium of 5.0 percent over growth stocks.
Studies have verified the existence of these risk premiums in international markets and emerging markets, as well as domestic markets and have found that the premiums are similar in size.
Every equity portfolio has some degree of exposure to each of the three risk factors. The equity to fixed-income allocation, small-cap stock to large-cap stock allocation, and value stock to growth stock allocation decisions are the all-important determinants of the risk and return of a portfolio.
Fama and French's factor model indirectly tells us that stocks, bonds, and other investments fall into separate asset classes (real estate versus commodities, for example) because they possess unique systematic risk and return characteristics. Conversely, the three-factor model tells us the decision of how much to allocate to different sectors (financial sector versus health care sector) is probably not as important because health-care stocks are not a separate asset class from stocks in general. Sectors do not have truly unique systematic risk and return characteristics.
Similarly, developed foreign markets are different from emerging markets. And allocations to individual countries (Germany versus Japan) are probably not as important. German or Japanese stocks are not a separate asset class from developed foreign-market stocks in general.
The following sections are designed to help you with these all-important allocations decisions. In each case, we will examine the reasons why investors should consider increasing or decreasing their exposure to an asset class. Examples are provided to illustrate the points made.