This is the most important asset allocation decision and the primary determinant of the expected return and risk of an investor's portfolio. We will now examine reasons why an investor should consider having a higher or lower equity allocation.
Longer time horizon. Younger investors have more human capital (more future labor income) to offset investment risk. In addition, investors with longer horizons have the ability to "wait out" a bear market without being forced to sell in order to meet cash-flow needs. This is especially true for investors who are still working. The longer your time horizon, the less likely equities will underperform fixed income investments.
High level of job stability. This is particularly true for individuals with income from jobs having little or no correlation to the economic risks of equity investing and the economy in general. A doctor or a tenured professor has income with bond-like characteristics. The income of an entrepreneur, whose business is affected by the performance of the stock market or does poorly when the economy is doing poorly, has equity-like characteristics.
High tolerance for risk. These individuals may have a full understanding and faith that in the long run, they will likely be compensated with higher returns for the increased risk. Or they may simply not watch their accounts closely. Most importantly, they are willing to accept the consequences if returns are well below those of safe fixed-income investments.
Need for higher returns to reach financial goals. In these cases, the willingness and ability to take risk should be carefully evaluated against the need to ensure that the investor fully understands the implications. An alternative to taking extra risk would be to either cut current consumption (providing more investment capital) or to revise goals to ones that are less financially demanding.
Retirees with multiple streams of stable income (pension and Social Security income) that are relatively high compared to needs. We can view these streams of income as quasi-fixed-income exposure. High-net-worth investors may also have other streams of income affecting the allocation process.
High marginal utility of wealth. Those whose next dollar earned provides a high marginal utility will have a high willingness and perhaps a high need to take risk.
Ability to adjust the "supply" of human capital. Consider the following: You develop a financial plan allowing you to retire at age sixty-five. But the market's return falls below the expected return, or you don't save as much as you expected. You need to work longer. The questions: Will you have the ability to continue in the labor force? What level of income will you be able to generate? Will the market allow you to sell your skills and at what price? Younger workers typically have more ability to adjust their supply of human capital. Those with a variety of skill sets also have a greater ability to adjust their supply to economic conditions. Those with more ability to adjust their supply of human capital can take more equity risk.
The presence of options one can exercise should a severe bear market create the risk the investment plan will fail. The more options one has, the more risk one can take. It is critical to only include options one is actually prepared to exercise.
The reasons to reduce equity exposure are the opposite of those above, with one additional issue to consider: Human capital should have less impact on appropriate allocations for retirees or high-net-worth investors, who typically have no earned income or minimal earned income relative to their net worth.
Here are some examples of how to apply the above guidelines.
Application: For a young business owner, the effect of a longer time horizon could be offset by the high correlation of the business owner's job and income prospects with the performance of the equity markets. Therefore, this young business owner might have a more conservative asset allocation than a young doctor with similar risk tolerance.
Application: Consider two retirees who are similar in every respect (age and risk tolerance) except for their sources of noninvestment income. The first retiree has both Social Security income and pension income from a very stable source. The second has only Social Security income. In this case, the first retiree could afford to be more aggressive with his investable assets.
Application: We have two doctors similar in every respect, including working at the same hospital, having the same risk tolerance, and performing the same type of job. The only relevant difference is age. The guidelines would say the older doctor should have a more conservative allocation. However, if they have the same current wealth and financial goals, the older doctor has less time to achieve those goals and thus has a higher need to take risk. The doctor will have to decide if the need to take risk or ability and willingness to take risk should dominate the decision. There is no right one answer, just one right for each individual.
Application: Two individuals are similar in all respects except one has a low tolerance for risk. The person with the lower risk tolerance becomes nervous and is unable to sleep well whenever the financial markets are in turmoil. This individual is more prone to panicked selling and should have a lower equity allocation.
Application: Two individuals are similar in all respects with the exception that one wishes to leave a large estate to a charitable organization or heirs. The other has a significantly lower bequeath motivation. The individual with the motivation to leave a large estate has a higher marginal utility of wealth and should have a higher equity allocation.
Application: Other things being equal, an investor with a primary goal of not running out of money in retirement should consider a lower equity allocation than one whose primary goal is to leave a large estate.
Application: A high-net-worth individual with a relatively low spending requirement should consider a lower equity allocation, even if they have a long investment horizon, stable job, and high level of tolerance for risk.
Investing in international stocks, while delivering expected returns similar to domestic stocks, provides the benefit of diversifying the economic and political risks of domestic investing. There have been long periods when U.S. stocks performed relatively poorly compared to international stocks. The reverse has also been true. Over the long term, returns have been similar. Thus, the gains from international diversification come from the relatively low correlation among international securities. This is especially important for those employed in the United States, as it is likely their labor capital is highly correlated with domestic risks.
The logic of diversifying economic and political risks is why investors should consider allocating at least 30 percent and as much as 50 percent of their equity holdings to international equities. To obtain the greatest diversification, benefit exposure to international equities should be unhedged: Hedging the currency risk increases the correlation of returns to U.S. equities.
Reduced Risk. The historical evidence suggests that raising the international allocation to at least 40 percent reduces portfolio risk (volatility).[3]But for many people, increasing the international equity exposure above 50 percent of the total equity portfolio does not make sense because of tracking-error concerns and from a risk-return perspective. Both are addressed in the discussion below.
Investor Has Non—U.S. Dollar Expenses. An investor may live part of the year overseas or frequently travel overseas. The investor should consider tailoring the portfolio to gain specific exposure to the currency in which the expenses are incurred. This could also be accomplished by making fixed-income investments in the local currency.
Tracking Error. Tracking error is defined as underperformance versus a benchmark. Some investors may not be able to stomach the tracking error associated with a portfolio with 40 percent of its equity invested overseas.
Table 4.1 illustrates tracking error risk by comparing the performance from 1991 through 2008 of a portfolio with a 100 percent allocation to U.S. stocks (S&P 500 Index) to the performance of a portfolio with a 60 percent allocation to U.S. stocks and 40 percent allocation to international stocks (MSCI EAFE Index).
While investors are pleased when there is positive tracking error (2002—07), many cannot tolerate underperforming their peers by significant margins when the tracking error turns negative (1995—98). Unless investors can tolerate negative tracking error and rebalance when appropriate, an international allocation will not be of much value.
Table 4.1. 1991—2008
S&P 500 (%) | MSCI EAFE (%) | 60% S&P 500/40% MSCI EAFE (%) | Portfolio Return Minus Return of S&P 500 (%) | |
|---|---|---|---|---|
Sources: Standard & Poors (S&P 500 Index), MSCI Barra (MSCI EAFE Index). | ||||
1991 | 30.5 | 12.5 | 23.2 | −7.2 |
1992 | 7.6 | −11.8 | −0.2 | −7.8 |
1993 | 10.1 | 32.9 | 19.2 | 9.1 |
1994 | 1.3 | 8.1 | 4.0 | 2.7 |
1995 | 37.6 | 11.6 | 27.2 | −10.4 |
1996 | 23.0 | 6.4 | 16.3 | −6.7 |
1997 | 33.4 | 2.1 | 20.8 | −12.6 |
1998 | 28.6 | 20.3 | 25.3 | −3.3 |
1999 | 21.0 | 27.3 | 23.5 | 2.5 |
2000 | −9.1 | −14.0 | −11.1 | −1.9 |
2001 | −11.9 | −21.2 | −15.6 | −3.7 |
2002 | −22.1 | −15.7 | −19.5 | 2.6 |
2003 | 28.7 | 39.2 | 32.9 | 4.2 |
2004 | 10.9 | 20.7 | 14.8 | 3.9 |
2005 | 4.9 | 14.0 | 8.6 | 3.7 |
2006 | 15.8 | 26.9 | 20.2 | 4.4 |
2007 | 5.5 | 11.6 | 8.0 | 2.4 |
2008 | −37.0 | −43.1 | −39.4 | −2.4 |
While international assets provide an important diversification benefit, international investing is more expensive because of higher trading costs and higher fund expenses. Allocating more than 50 percent to international equity may not be optimal from a risk-return perspective. An exception might be an investor whose labor capital risk is substantial. Tilting heavily toward international equity can diversify that risk.
To learn more about the benefits of international investing read Chapter 4 of The Only Guide to Alternative Investments You'll Ever Need.
Emerging markets comprise those nations whose economies are considered developing or emerging from underdevelopment, including almost all of Africa, Eastern Europe, Latin America, Russia, the Middle East, and much of Asia, excluding Japan, Hong Kong, and Singapore. Many investors shy away from emerging markets, viewing them as either highly risky investments or pure speculations. The riskiness of emerging markets should not preclude investors from allocating some portion of their portfolio to them. Modern portfolio theory (MPT) tells us that sometimes we can add risky assets and actually reduce the risk of the overall portfolio. The reason is the diversification benefit.
Another reason to consider investing in emerging markets is that because it is a risky asset class, an efficient market will appropriately price that risk. The result is higher expected returns. Historical evidence shows that emerging market equities have high returns with high volatility. They also have low correlations to both domestic and international equities. And the evidence shows that including a small amount of emerging markets equity in a portfolio increases that portfolio's return while leaving volatility roughly the same.
Increased expected return. The primary reason to increase one's allocation to emerging markets is to increase the expected return of the portfolio. Investors who need to increase their expected return to meet their financial goals can use an allocation to emerging markets to help meet this objective.
Tracking error. Emerging markets equity has a relatively low correlation with both the overall U.S. markets and international developed markets. Therefore, emerging markets' returns may be below their average when the U.S and/or other developed markets are producing above-average returns. Some investors may not be able to tolerate this tracking error. Also, the correlation of emerging markets equity could be high enough in some periods that inclusion of a large allocation (greater than 10 percent of the equity allocation) to emerging markets could actually increase the volatility of the overall portfolio to an unacceptable level.
The correlation of emerging markets to other equity asset classes typically rises during periods of financial turmoil. Thus, when the low correlation is most needed, the correlation is likely to increase. Investors who are either highly sensitive to tracking error risk or highly risk averse should consider limiting their exposure to emerging markets.
To learn more about the benefits of investing in emerging markets, read Chapter 4 of The Only Guide to Alternative Investments You'll Ever Need.
The value versus growth decision is another important allocation choice investors need to make. When thinking about the guidelines below, remember that the market portfolio is completely neutral with respect to value and growth exposure. It is neither value- nor growth-tilted.
Most investors with value-tilted portfolios choose to do so for one of three reasons. They believe:
Value stocks are riskier than growth stocks. Therefore, value stocks should provide a risk premium in the same way that equities should provide a risk premium over the return of safer fixed-income investments. This is the traditional finance point of view.
Value stocks are not riskier than growth stocks. They believe investors systematically overprice growth stocks and underprice value stocks. The value premium is a free lunch, not a risk premium. They argue that value stocks provide superior risk-adjusted returns than growth stocks. This is the behavioral finance point of view. Behavioralists use the Internet and technology bubble of the late 1990s to bolster their argument.
Both traditionalists and behavioralists are partially right: Value stocks are riskier than growth, but the risk premium has been too large to be explained by the excess risk. While it may not be a free lunch, it just might be a free stop at the dessert tray.
We will assume the traditional financial view of the value premium to be a risk story, but it is helpful to be aware of all viewpoints.
Increased expected return with increased risk. From a traditional finance point of view, investors should tilt toward value if they need to increase the expected return of their portfolios to meet their goals—but only if they are willing and able to accept the incremental risk of value stocks.
Diversification of sources of risk. Consider an investor needing a certain rate of return to achieve his goals. That rate of return can be achieved with a certain exposure to beta (total stock market) risk. The appropriate allocation to the total market (which has no value exposure) might be 60 percent. Another way to achieve the same goal is to lower the exposure to beta (50 percent) but add sufficient value exposure so that the two portfolios have the same expected return. Historically, the value-tilted portfolio with a lower exposure to beta has exhibited less volatility. The reasons are that the value premium has been less volatile than the equity premium and has low correlation to the equity risk premium. (Appendix A provides further explanation.)
Application: A high-net-worth investor with a low marginal utility of risk may still want to achieve a certain return. The downside risk of the portfolio can be reduced by lowering the exposure to beta while increasing the exposure to the value premium. The trade-off is a lower probability of producing returns above the expected.
Application: An individual whose labor capital has a low correlation to the value premium should consider increasing their exposure to value stocks. Typical examples are tenured professors, doctors, and retirees. Another good candidate for increasing the exposure to value stocks is a high-net-worth investor whose labor capital is a low percentage of his overall net worth.
Reduced risk. Those taking the traditional finance point of view believe in tilting towards growth stocks to reduce portfolio risk. Investors who are exposed to value risk factors in ways other than investments should use this strategy. This includes owners of distressed businesses, employees and top-level managers of value companies, as well as retirees who receive (or in the future will receive) pension benefits from a value company. For this type of investor, a neutral exposure to value or even a growth tilt (compared to the market) is more appropriate.
Tracking error. Portfolios tilted toward value will not move in lockstep with the overall market. Investors with value-tilted portfolios must be able to stomach the tracking error occurring during the inevitable periods of value underperformance. Depending on the investor, a more neutral exposure to value might make sense.
Application: An owner or employee of a value company (a company with a high BtM ratio) should probably not tilt as heavily toward value stocks as a tenured professor. Other individuals who should consider not tilting to value stocks (or limiting their tilt) are construction workers, automobile workers, or any employee or owner of a highly cyclical business. For these investors, a neutral exposure to value or even a growth tilt (compared to the market) might be more appropriate.
Considerations on how much to invest in small-cap stocks versus large-cap stocks are basically the same as for the value versus growth decision. Small-cap stock risk tends to appear during periods of economic distress, which is when value stocks also tend to perform poorly. Large-cap stocks tend to perform better during these periods because large companies have more diverse sources of capital, are less likely to be cut off from those sources, and are less prone to bankruptcy.
Increased expected return with increased risk. Investors should tilt toward small-cap stocks if they need to increase the expected return from their portfolios to meet their goals—but only if they are willing and able to accept the incremental risk of small-cap stocks.
Stable human capital. Investors not particularly exposed to economic-cycle risk might consider tilting their portfolios toward small-cap stocks. Doctors, tenured professors, and retirees with defined benefits generally fit this description. Advertising company executives, construction workers, and most commissioned salespeople are more exposed to this type of economic-cycle risk.
Diversification of sources of risk. As was discussed in the value section, tilting more to small-cap stocks maintains the expected return of the portfolio while lowering the exposure to beta. This reduces the potential dispersion of returns. The diversification benefit arises from the low correlation of the size risk factor to both the market risk and value risk factors. (Appendix A provides further explanation.)
Less stable human capital. Tilting toward large-cap stocks might be a valid strategy for investors vulnerable to periods of economic distress. Investors whose business, employment, or income might be negatively affected by a poor economy might want to tilt toward larger, safer stocks.
Lower risk. Tilting toward large-cap stocks reduces the volatility of a portfolio. Risk-averse investors and those with a low marginal utility of wealth may prefer to focus on reducing volatility as opposed to maximizing returns.
Application: You are a small business owner whose company tends to do poorly when the overall economy does poorly. With inherent exposure to small-cap risk, you might want to tilt toward large-cap stocks.
Academic studies demonstrate that both domestic and international equity real estate investment trusts (REITs) offer an attractive risk/ return trade-off and provide meaningful diversification benefits to portfolios. The reasons equity real estate should be considered a core asset are:
REITs reduce the overall risk of the portfolio by adding an asset class that responds to events differently from other asset classes: Its correlation to other asset classes is low
REITs have expected returns well above the risk-free rate
As real assets, REITs provide a reasonably good long-term hedge against unexpected inflation
Adding an allocation to REITs allows investors to create a portfolio more reflective of the overall investment universe.
There are two ways to gain real estate exposure: (1) through directly owned real estate; (2) through REITs, using a product like Vanguard's REIT mutual fund. REITs are the stocks of companies having real estate operations. Both forms of real estate exposure should be expected to lower the volatility of an equity-only portfolio.
Domestic REITs have low correlation to both domestic and international equities. International REITs have even lower correlation to domestic equities and low correlation to other international equities. Thus, both domestic and international REITS are excellent diversifiers of equity risks.
Lower portfolio volatility. REITs and directly owned real estate have low correlation with most other asset classes. This is true of both domestic and international REITs.
Increase the income return of the portfolio. Since REITs are required to pay out most of their annual earnings, they could be beneficial for a charitable remainder trust (CRT).
Individuals who already have fairly diversified real estate exposure. If they already have it, through their business or other investments, they might not need additional real estate exposure.
Increased tracking error. An allocation to real estate increases the tracking error of the portfolio relative to broad-market indices.
Tax inefficiencies associated with REITs. REITs are prime candidates for tax-deferred accounts. See Chapter 10.
No "best" place to hold international REITs. Because their dividends are nonqualified, they should not be placed in taxable accounts unless one is in the lowest tax brackets. Conversely, because of the loss of the foreign tax credit (FTC), the cost of holding them in tax-advantaged accounts is increased. The cost of losing the FTC is about 9 percent of the dividend yield.
A primary residence is clearly real estate, but it is very undiversified real estate. First, it is undiversified by type. There are many types: office, warehouse, industrial, multi-family residential, hotel, and unimproved land. Owning a home provides exposure to just the residential component of the larger asset class of real estate. Even by excluding multi-family residences, it is only exposure to the single-family component. Second, a home is undiversified geographically. Home prices might be rising in one part of the country and falling in another. Third, home prices may be more related to an exposure to an industry than to real estate in general. For example, in the 1980s, home prices in Texas and in oil-producing regions in general collapsed when oil prices collapsed. One's home provides some exposure to real estate but not diversified exposure.
A home is a very different financial asset. You cannot perform the normal portfolio maintenance tasks such as rebalancing and tax management. While clearly an asset with value that should appear on the balance sheet and be considered a possible source to fund future cash-flow needs (through a reverse mortgage or sale), it should be excluded from consideration when thinking about asset allocation.
To learn more about the benefits of real estate investing, read Chapter 1 of The Only Guide to Alternative Investments You'll Ever Need.
Commodities fall within the broad category of hard assets and are an interesting class from a portfolio perspective. While a highly volatile asset class, from 1970 through 2008 they have exhibited negative correlation with both equities and bonds.
The expected return of fully collateralized commodity futures is probably only marginally higher than that of safe investments like high-quality fixed income. However, the combination of commodities' high volatility and negative correlation to equities and nominal return bonds historically results in less risky, more efficient portfolios. Those including commodities have produced higher risk-adjusted returns. Adding small amounts of commodities to a portfolio has reduced volatility without negatively impacting compound returns in a significant way. Commodities are worthy of consideration for inclusion in a globally diversified portfolio.
Investors should consider an allocation to CCF of between 5 and 10 percent of their equity allocation.
The primary reason to add commodity futures to a portfolio is to reduce the overall volatility of that portfolio without the negative impact on returns produced by adding fixed-income assets. This may seem counterintuitive because commodity futures themselves are very volatile, but historically commodity futures have had negative correlation with most every other major asset class. Negatively correlated assets act like portfolio insurance. Including them reduces potential dispersion of returns, reducing the opportunity for greater than expected portfolio returns while lowering the risk of less than expected ones.
Risk-averse investors. The more risk averse, the greater the allocation to commodities—but no more than 10 percent of the portfolio.
Those in the withdrawal phase of their investment careers. Volatility negatively impacts the odds of a portfolio running out of money for any given withdrawal rate. Being negatively correlated with other portfolio assets, adding commodities reduces portfolio volatility, reducing the odds of a portfolio running out of money while simultaneously reducing the odds of leaving a large estate. Retirees and endowments are prime candidates for considering higher commodities allocations.
Investors exposed to the risks of unexpected inflation. This includes both individuals on fixed income (fixed annuities or pensions) and those owning longer-term bonds.
Investors needing greater return from their fixed income investments than short-term bonds can provide. In these circumstances, it is better to take duration risk rather than credit risk. CCF can hedge the risks of longer-term bonds.
Investors concerned about event risks that could negatively impact equities and nominal return bonds.
Adding commodities to a portfolio increases the odds of success in Monte Carlo simulations. Even a 3 to 5 percent allocation will generally improve the odds of success by about 2 percent. The offset is that the allocation reduces the odds of achieving a very large estate. The allocation to commodities should be taken from the equity allocation. If taken from the fixed-income allocation, portfolio volatility will increase, defeating the main purpose of reducing such risk.
Application: Investors who have recently retired may want to reduce the volatility of their portfolios. Adding commodities has historically produced that result.
Risk-tolerant investors or investors needing a high return to reach their financial goals may not be willing to give up expected return in exchange for lowering portfolio volatility. Furthermore, the addition of CCF increases tracking error risk. Perhaps most importantly, commodities should be considered only by those able to view the results of the whole portfolio, ignoring returns of the component parts. While to some degree this is true of all assets with low correlation, it is especially true in the case of CCF, which are highly volatile and have relatively low expected returns compared to the equities they displace in a portfolio. Due to the tax inefficiency of CCF, they should not be included in taxable accounts but in tax-deferred accounts. See Chapter 10 for more details on asset location.
Application: A young investor in the early stages of accumulation may not want to sacrifice expected return for lower volatility. This type of investor might choose to exclude commodities and accept higher volatility.
To learn more about commodities as an asset class, read Chapter 3 of The Only Guide to Alternative Investments You'll Ever Need.
SRI has been referred to as "double-bottom-line" investing. You are seeking both profitable investments and those meeting your personal ethical standards. You sleep with a clear conscience. Some investors don't want their money supporting companies that sell tobacco products, alcoholic beverages, or weapons, or companies that rely on animal testing as part of their research and development efforts. Other investors may be concerned about social, environmental, governance, labor, or religious issues. SRI encompasses many personal beliefs, not one set of values.
SRI funds cannot be endorsed if the sole criteria are investment-related issues. They add incremental costs (higher expense ratios) and are less effectively diversified. They are inefficient investments. However, for those investors willing to pay a price for investing according to their values, passively managed funds should be used to implement an SRI strategy. A subset of SRI is typically referred to as "sustainability" or "green" investing (see Glossary).
To learn more about SRI, read Chapter 10 of The Only Guide to Alternative Investments You'll Ever Need.