Today, we’re going to discuss one of the most important concepts in investing: asset allocation. Over the next few minutes, we’ll cover: • Asset allocation basics: what asset allocation is and how it works • The key benefits of asset allocation • How to use asset allocation in your investment portfolio
Asset allocation is the strategic process of dividing your investments among different asset classes, such as stocks, bonds and cash equivalents. Short-term Treasuries and Certificates of Deposit are typical cash equivalents. • Stocks, bonds and cash are the three basic building blocks of asset allocation. • A diversified long-term portfolio should include all three.
To get the full benefit of asset allocation, you can diversify further within each basic asset class. Let’s start with stocks. Your stock investments can be diversified by • Style—growth and value • Size of company—small, mid and large • Geographical region—domestic and foreign • Sector, such as technology, energy and healthcare As your portfolio grows, it often makes sense to refine your asset allocation plan to include some or all of these stock market segments.
Let’s start off our analysis of stocks with a deeper look at the two main styles: growth and value. Growth stocks are typically the stocks of companies whose earnings are expected to grow at above average rates relative to the market. Common characteristics include a low dividend yield, high expected earnings growth, high price-to-earnings ratio and high price-to-book ratio. Some growth stocks you may be familiar with include Starbucks, Intel and NIKE. Value stocks, on the other hand, tend to trade a lower prices relative to their fundamentals. Common characteristics include a high dividend yield, low expected earnings growth, low price-to-earnings ratio and low price-to-book ratio. Some value names you might know are Bank of America, Ford and Allstate. You can see that value and growth stocks have very different characteristics. A well-allocated portfolio should include both.
A second way to define stocks is by size. Small cap stocks are the stocks of smaller and usually younger companies. Some small cap names you may be familiar with are Ann Taylor and Palm, Inc. On the other hand, large cap stocks are usually issued by larger and more established companies such as General Motors or FedEx. Mid cap stocks fall somewhere in between. While small and mid cap stocks have outperformed large cap stocks over the last 10 years, they have also been significantly more risky.
With over half of the world’s stock market residing outside the US, you should consider diversifying across geographies as well.
Many of you may have heard tips from your friends on the hottest technology or energy stock. When you hear tips like these, be wary of investing too heavily in one sector. As you can see in this chart, top performing sectors are fickle. Technology, the top performing sector in 1999, only appeared in the top 3 twice in the last 10 years. Consumer staples, the top performing sector in 2008, also only appeared in the top 3 twice. Your best bet for good long-term performance is to diversify across all sectors so that you always participate in the top-performing sectors.
As with stocks, you can diversify further within the bond asset class to achieve greater benefits from asset allocation. • Your bond investments can be divided by sector, credit quality, maturity and geographical region. • As your portfolio grows, it makes sense to consider refinements to your bond market allocation to include some or all of these bond market segments.
This chart shows various sectors of the taxable fixed income market ranked from best to worst each year for the last 5 years. US Treasuries, typically considered a stable and reliable investment, was the top performing sector in 2008, returning 14.0%. However, US Treasuries was the worst performing sector in 2006 with 3.1%. This sector has been very volatile over the last five years, having at least as many ups and downs as High Yield Bonds (shown in dark green). The Investment Grade Bonds sector, which combines treasuries, corporates and mortgages has been the most reliable and best performing sectors over the last five years.
This chart shows various maturities of the municipal fixed income market ranked from best to worst each year for the last 5 years. While the longest maturities performed best from 2004-2006, you would have been better off in 2007 and 2008 investing in the Municipal Master Index due to the reversal. It is impossible to predict with any certainty which sector or maturities will “win” at the beginning of each year. That is why it is important to invest in a portfolio which is diversified across maturities.
Asset allocation offers three major benefits: • It helps you gain exposure to rotating market leaders. • It helps reduce exposure to volatility. • Finally, asset allocation can actually help increase your returns.
As this chart illustrates, no one asset class is a top performer every year. Exposure to a broad range of asset classes helps you in two ways: • If your assets are divided among many different market sectors, you’ll benefit when one asset class does well. • You’ll have a cushion against a downturn in any one specific market sector.
This chart is an illustration of the efficient frontier created by combining stocks and bonds in different proportions. If you tend to prefer bonds, you’re probably more risk averse. However, holding an all bond portfolio may not actually provide the greatest risk protection. Because stocks are not highly correlated with bonds, adding them to an all bond portfolio may allow you to increase return while decreasing risk. If, on the other hand, you lean toward stocks, you may benefit from adding some bonds to your portfolio. Allocating even just a small portion of your portfolio to bonds may allow you to substantially decrease risk while sacrificing only minimal returns. This may lead to an increase in risk-adjusted returns for the portfolio.
Many investors turn to fixed income for a reasonable level of return with less risk than stocks. However, by adding a moderate allocation of stocks to the portfolio, you could potentially achieve a higher return with the same standard deviation. If you are willing to allocate a little more to stocks, you may be able to achieve an even greater return with little additional risk.
Your asset allocation plan should reflect your personal financial goals, time horizon and risk tolerance. Consider these two portfolios. The aggressive model reflects youth and high risk tolerance. This investor should be prepared for considerable volatility with such an aggressive mix of investments. However, over the long term, this portfolio is positioned for returns that are well above average. The conservative model is more cautious. This investor may be ready to retire. Or volatility may be uncomfortable, and this investor wants to avoid losing sleep over investment returns. This portfolio is likely to generate steadier returns than the first. However, those returns are also likely to be significantly lower over the long term.
Just like you car needs to be tuned up to keep it functioning as it should, your asset allocated portfolio needs to be rebalanced to keep its risk and return characteristics in line with your goals. Consider this example: If your portfolio was divided 50/50 between stocks and bonds on December 31, 1984 and you did nothing to adjust it over time, your allocation would have shifted to 56/44 by December 31, 2008 because stocks were stronger performers than bonds during that period. It may seem surprising that the portfolio with a lower allocation to stocks actually outperformed. But that’s due to the fact that rebalancing reinforces the common sense investing rule of buy low, sell high. You buy more of asset classes that are underperforming and may be due for a rebound (buying low). Conversely, you sell the assets that have had a good run but may not perform as well in the future (selling high).
While rebalancing helps keep your portfolio on track, one of the best ways to help it grow even faster is to invest regularly even if it’s relatively small amounts. This allows you to employ the strategy called “dollar cost averaging.” The table shows how dollar cost averaging works: • Start by choosing a mutual fund, an investment amount and an investment interval. Monthly investments work best because you can think of them as part of your budget. • As you can see on the table, every month you invest the same amount in the same fund. • After six months, this table shows that the average price for the shares you bought was higher than your average cost. That’s because you took advantage of the ups and downs of the share price. • This is an extreme example, but it shows that with dollar cost averaging, you can turn market volatility into opportunity; you will buy more shares when the fund’s price is low and fewer shares when prices are higher. • Dollar cost averaging doesn’t guarantee a profit or protect against a loss. However, over the long term, your average cost should be lower than the average price you paid for fund shares. . To summarize, you (along with your financial professional) should: • Choose investments based on your goals, risk tolerance and time horizon. • Balance risk by blending investments that expose you to different market cycles, investment styles and geographical areas. • Monitor your investments and rebalance your mix as necessary.
Asset Allocation Basics Key Benefits of Asset Allocation How to Use Asset Allocation | NOT FDIC INSURED | MAY LOSE VALUE | NO BANK GUARANTEE |
Asset Allocation: A Strategic Division of Assets Asset allocation basics Stocks Cash Equivalents Bonds
Diversify Further Within Stocks Asset allocation basics Style Growth and Value Small and mid-sized company stocks involve greater risks than those customarily associated with larger companies. Foreign investment entails special risks. These risks are heightened in emerging markets. Emphasizing a particular industry sector involves greater risk than customarily associated with a more diversified portfolio. Size Small, Mid and Large Sector Technology, Energy and Healthcare Geography Domestic and Foreign
Style: Growth and Value Asset allocation basics Investing involves risk. The information shown is for illustrative purposes only. Higher Lower Growth Growth Growth Value Value Value Value Growth Price/ Earnings Ratio Price/ Book Ratio Expected Earnings Growth Rate Dividend Yield
Size: Small, Mid and Large Asset allocation basics 15-Year Risk vs. Return (as of December 31, 2009) Source: PSN Enterprise. Large Cap is represented by the S&P 500 Index. Mid Cap is represented by the S&P 400 Mid Cap Index. Small Cap is represented by the S&P 600 Small Cap Index. Past performance is no guarantee of future results. Returns assume reinvestment of all distributions. Risk is measured by standard deviation of quarterly returns. It is not possible to invest directly in an index. Return Risk Large Cap Mid Cap Small Cap
Geography: Domestic and Foreign Asset allocation basics Global Market Share Over Time 1970 2009 Source: Standard & Poor’s; Morgan Stanley Capital International. US companies represented by the S&P 500 Index. Non-US companies represented by the MSCI EAFE Index.
Sector: Technology, Energy and Healthcare Asset allocation basics Year First Second Third Top Three Sectors: Total Returns (2000-2009) Source: Standard & Poor’s, a division of The McGraw-Hill Companies; Lipper, Inc. Past performance does not guarantee or indicate future results. Investing involves risk. Standard & Poor’s offers sector indexes on the S&P 500 based upon the Global Industry Classification Standard (GICS), a standard that is jointly maintained by Standard & Poor’s and Morgan Stanley Capital International (MSCI). Each stock is classified according to sector, industry group, industry and sub-industry according to its largest source of revenue. For informational purposes only. This information does not represent the performance of any particular investment. The S&P 500 Index and the S&P sectors cannot be invested in directly. Utilities Materials Energy 2007 Utilities Healthcare Cons. Staples 2008 Cons. Disc. Materials Technology 2009 Financials Healthcare Utilities 2000 Utilities Energy Telecom 2006 Financials Utilities Energy 2005 Telecom Utilities Energy 2004 Cons. Disc. Materials Technology 2003 Energy Materials Cons. Staples 2002 Industrials Cons. Disc. Materials 2001
Diversify Further Within Bonds Asset allocation basics Fixed income securities are subject to the risks associated with debt securities including credit, price and interest rate risk. Bond values will decline as interest rates rise. Lower-rated bonds may contain more risk due to the increased possibility of default. US government bonds are guaranteed as to payment of principal and interest if held to maturity. Foreign investment entails special risks. Sector Corporate, Government and Mortgage Credit Quality High and Low Geography Domestic and Foreign Maturity Long, Intermediate and Short
Diversify Further Within Bonds: Sector & Credit Asset allocation basics Source: PSN Enterprise. For informational purposes only. Past performance does not guarantee or indicate future results. Investing involves risk. It is not possible to invest directly in an index. The information shown does not reflect any particular investment. Performance returns assume the reinvestment of all distributions. High Yield Bonds are represented by the Merrill Lynch US High Yield Master Index. Cash is represented by the Merrill Lynch US Treasury Bill 3 Month Index. US Treasuries are represented by the Merrill Lynch US Treasury Bill Master Index. Low Duration Bonds are represented by the Merrill Lynch 1-3 Year Corporate & Government Index. Investment Grade Bonds are represented by the Merrill Lynch US Domestic Master Index. Calendar Year Total Returns US Treasuries -3.7 % High Yield Bonds -26.2% High Yield Bonds 2.2% US Treasuries 3.1 % Low Duration Bonds 1.8 % Cash 0.2 % Cash 2.1 % Cash 5.0 % Low Duration Bonds 4.3 % Investment Grade Bonds 2.6 % Low Duration Bonds 4.8 % Low Duration Bonds 4.7 % Low Duration Bonds 6.9 % Investment Grade Bonds 4.3 % High Yield Bonds 2.7 % Investment Grade Bonds 5 .2% Investment Grade Bonds 6 .2% Investment Grade Bonds 7 .2% Cash 4.9 % US Treasuries 2.8% High Yield Bonds 56.3 % US Treasuries 14.0 % US Treasuries 9.1 % High Yield Bonds 11.8 % Cash 3.1 % 2009 2008 2007 2006 2005
Diversify Further Within Bonds: Maturity Asset allocation basics Source: PSN Enterprise. For informational purposes only. Past performance does not guarantee or indicate future results. Investing involves risk. It is not possible to invest directly in an index. The information shown does not reflect any particular investment. Performance returns assume the reinvestment of all distributions. Muni 1-3 Years is represented by the ML 1-3 Year Municipal Securities Index. Muni 3-7 Years is represented by the ML 3-7 Year Municipal Securities Index. Muni 7-12 Years is represented by the ML 7-12 Year Municipal Securities Index. Muni 12-22 Years is represented by the ML 12-22 Year Municipal Securities Index. Muni 22+ Years is represented by the ML 22+ Year Municipal Securities Index. Calendar Year Total Returns Muni 1-3 Years 4.2% Muni 22+ Years -14.5% Muni 22+ Years 0.9% Muni 1-3 Years 3.3% Muni 3-7 Years 1.3% Muni 3-7 Years 7.2% Muni 12-22 Years -6.3% Muni 12-22 Years 2.9% Muni 3-7 Years 3.4% Muni 1-3 Years 1.4% Muni 7-12 Years 9.8% Muni 7-12 Years 2.2% Muni 1-3 Years 4.7% Muni 7-12 Years 4.6% Muni 7-12 Years 2.8% Muni 12-22 Years 17.5% Muni 1-3 Years 5.2% Muni 7-12 Years 4.8% Muni 12-22 Years 5.4% Muni 12-22 Years 4.4% Muni 22+ Years 23.6% Muni 3-7 Years 5.9% Muni 3-7 Years 5.3% Muni 22+ Years 6.6% Muni 22+ Years 6.8% 2009 2008 2007 2006 2005
Three Major Benefits of Asset Allocation Key benefits of asset allocation 1 Gain exposure to rotating market leaders 2 Help reduce exposure to volatility 3 Potentially increase your returns
Gain Exposure to Rotating Market Leaders 1 Key benefits of asset allocation Year First Second Third Source: PSN Enterprise. Past performance does not guarantee or indicate future results. Investing involves risk. This information is for illustrative purposes only. It does not reflect any particular investment. Large Cap Value stocks—Russell 1000 Value Index. Large Cap Growth stocks—Russell 1000 Growth Index. Large Cap Core stocks—S&P 500 Index. Small Cap stocks—Russell 2000 Index. International stocks—MSCI EAFE Index. Fixed Income—Barclays Capital US Aggregate Index. Cash—Merrill Lynch US Treasury Bill 3 Month Index. It is not possible to invest directly in an index. Top three asset classes: Total Returns 2000-2009 Fixed Income International Large Cap Growth 2007 Small Cap Cash Fixed Income 2008 Small Cap International Large Cap Growth 2009 Cash Large Cap Value Fixed Income 2000 Small Cap Large Cap Value International 2006 Large Cap Growth Large Cap Value International 2005 Large Cap Value Small Cap International 2004 Large Cap Value International Small Cap 2003 Large Cap Value Cash Fixed Income 2002 Small Cap Cash Fixed Income 2001
Help Reduce Exposure to Volatility 2 Key benefits of asset allocation Sources: BlackRock; PSN Enterprise. Past performance does not guarantee or indicate future results. Investing involves risk. Stocks are represented by the S&P 500 Index. Bonds are represented by the Merrill Lynch US Treasuries 10+ Year Bond Index. Bonds held to maturity offer a fixed rate of return. It is not possible to invest directly in an index. The Efficient Frontier: 1980-2009 100% Stocks 100% Bonds
Potentially Increase Your Returns 3 Key benefits of asset allocation Return: 7.4% Risk: 3.5% Cash 24% Stocks 8% Bonds 68% Return: 7.6% Risk: 3.5% Cash 20% Bonds 80% Higher Return Portfolio Fixed Income Portfolio Asset allocation does not assure a profit or protect against a loss. Source: PSN Enterprise, BlackRock. Risk and return are measured by standard deviation and compound annual return, respectively. They are based on monthly data over the period 1984 to 2008. Stocks are represented by the performance of the S&P 500® Index, bonds by the Barclays Capital Bond Index and cash by the Merrill Lynch 3-month Treasury Bill Index. It is not possible to invest in an index. Past performance does not guarantee or indicate future results. The information provided is for illustrative purposes only and is not meant to represent the performance of any particular investment.
Asset Allocation Is Personal How to use asset allocation Aggressive Conservative Small-Cap Stocks Large-Cap Stocks High-Yield Bonds International Stocks Mortgage Bonds Cash Government Bonds The above allocations are for illustrative purposes only and are not intended as investment advice. 10% 10% 25% 10% 40% 5% 20% 20% 40% 5% 15% Mortgage Bonds Cash Large-Cap Stocks International Stocks
Asset Allocation Requires Tune Ups How to use asset allocation *Standard deviations are calculated using monthly returns. Sources: BlackRock, PSN Enterprise. Stocks are represented by 25% Russell 1000 Value Index, 25% Russell 1000 Growth Index, 25% Russell 2500 Index and 25% MSCI EAFE Index. Bonds are represented by the Barclays Capital US Aggregate Bond Index. It is not possible to invest directly in an index. Assumes reinvestment of all dividends Investment of $1,000,000 in a Portfolio Containing 50% Stocks and 50% Bonds on 1.1.85 Bonds 50% Stocks 50% Bonds 50% Final Portfolio Value: $10,485,848 25-Year Average Annual Return: 9.9% 25-Year Standard Deviation*: 8.3% Portfolio with Annual Rebalancing on 12.31.09 Bonds 38% Stocks 62% Final Portfolio Value: $9,413,351 25 Year Average Annual Return: 9.4% 25 Year Standard Deviation*: 10.2% Portfolio without Rebalancing on 12.31.09 Difference Final Portfolio Value: $1,072,497 25-Year Average Annual Return: 0.5% 25-Year Standard Deviation*: 1.9%
Dollar Cost Averaging: Discipline Rewarded How to use asset allocation Hypothetical example. Does not represent any particular investment. No investment is risk free, and a systematic investment plan does not ensure profits or protect against losses in declining markets. Because Dollar-Cost averaging involves continuous investment in securities regardless of fluctuating price levels, you should carefully consider your ability to continue to purchase during periods of price declines. Add dollar cost averaging $19.44 ($12,000/617.3) $20.25 ($243/12) Average Cost per Share (Dollar-Cost Averaging) Average Price per Share $12,000 617.3 $243 Total $1,000 37 $27 December $1,000 40 $25 November $1,000 50 $20 October $1,000 58.8 $17 September $1,000 66.7 $15 August $1,000 66.7 $15 July $1,000 62.5 $16 June $1,000 55.6 $18 May $1,000 50 $20 April $1,000 50 $20 March $1,000 40 $25 February $1,000 40 $25 January Cost Shares Purchased Price/Share Month Purchased
Risks of Asset Allocation 1 General market risk (value of portfolios will fluctuate with market conditions) 2 Asset allocation does not assure a profit or protect against a loss 3 Performance is dependant on ability to select appropriate asset categories
Important Information The S&P 500 Index is an unmanaged index that consists of the common stocks of 500 large capitalization companies, within various industrial sectors, most of which are listed on the New York Stock Exchange. The S&P MidCap 400 Index is a market value-weighted index that consists of 400 domestic stocks and measures the performance of the midsize company segment of the US market. The S&P 600 SmallCap 600 Index is an unmanaged market-value weighted index consisting of 600 domestic stocks, representing all major industries in the small-capitalization of the US stock market. The Merrill Lynch US High Yield Master Index tracks the performance of below investment-grade US dollar-denominated corporate bonds publicly issued in the US domestic market. The Merrill Lynch US Treasury Bill 3 Month Index is an unmanaged index based on the value of a 3-month Treasury Bill assumed to be purchased at the beginning of the month and rolled into another single issue at the end of the month. The Merrill Lynch US Treasury Bill Master Index tracks the performance of all outstanding Treasury Bills issued by the US government. The Merrill Lynch 1-3 Year Corporate & Government Index is comprised of investment grade corporate bonds and agency and US Treasury securities with a maturity ranging from one to three years. The Merrill Lynch US Domestic Master Index includes a mixture of government bonds, corporate bonds and mortgage pass-through securities of investment-grade quality, having maturity greater than or equal to one year. The Merrill Lynch 1-3 Year Municipal Securities Index tracks the performance of municipal investment-grade debt of US municipalities having at least one year and less than three years remaining term to maturity. The Merrill Lynch 3-7 Year Municipal Securities Index tracks the performance of municipal investment-grade debt of US municipalities having at least three years and less than seven years remaining term to maturity. The Merrill Lynch 7-12 Year Municipal Securities Index tracks the performance of municipal investment-grade debt of US municipalities having at least seven years and less than 12 years remaining term to maturity. The Merrill Lynch 12-22 Year Municipal Securities Index tracks the performance of municipal investment-grade debt of US municipalities having at least 12 years and less than 22 years remaining term to maturity. The Merrill Lynch 22+ Year Municipal Securities Index tracks the performance of municipal investment-grade debt of US municipalities having at least 22 years remaining term to maturity. The Merrill Lynch Municipal Master Index tracks the performance of the investment-grade US municipal bond market.
Important Information (cont’d) The Russell 1000 Value Index is composed of those Russell 1000 securities with less-than-average growth orientation, generally having low price-to-book and price-to-earnings ratios, higher dividend yields and lower forecasted growth values. The Russell 1000 Growth Index is composed of those Russell 1000 securities with greater-than-average growth orientation, generally having higher price-to-book and price-to-earnings ratios, lower dividend yields and higher forecasted growth values. The Russell 2000 Index is a market-weighted small capitalization index composed of the smaller 2,000 stocks, ranked by market capitalization, of the Russell 3000 Index. The Russell 2500 Index consists of the bottom 500 companies in the Russell 1000 Index, as ranked by total market capitalization, and all 2,000 companies in the Russell 2000 Index. The Morgan Stanley Capital International (MSCI) EAFE Index represents international equity performance and is a capitalization-weighted index based on securities from Europe, Australasia and the Far East. The Barclays Capital Aggregate Bond Index is an unmanaged index composed of more than 5,000 investment-grade taxable bonds. The Merrill Lynch US Treasuries 10+ Year Index is an unmanaged index which includes US Treasury securities with maturities greater than 10 years.