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Guideto Asset Allocation
- 1. Page CC0000.085.0205Welcome “ The Markets and Asset Allocation” Presented by: Troy C. Patton, CPA and Fund Manager
- 2. Page CC0000.085.0205 February 15, 2005 The markets can be puzzling if we don’t understand the basics. Shares of The Archer Funds are not deposits or obligations of any bank, are not guaranteed by any bank are not insured by the FDIC or any other agency, and involve investment risks, including the possible loss of the principal amount invested. Take the puzzle out of the markets. The Archer Funds
- 3. Page CC0000.085.0205What drives the Market? 1968 1978 2007 Inflation and What It’s Done to Our Money
- 4. Page CC0000.085.0205Inflation by Decade
- 5. Page CC0000.085.0205What does Inflation mean for the Markets? Source: Standard and Poor’s
- 6. Page CC0000.085.0205 February 15, 2005 The Art of Balancing Risk and Reward To Meet Objectives Shares of The Archer Funds are not deposits or obligations of any bank, are not guaranteed by any bank are not insured by the FDIC or any other agency, and involve investment risks, including the possible loss of the principal amount invested. A Guide to Asset Allocation The Archer Balanced Fund
- 7. Page CC0000.085.0205Putting the Puzzle together Reasons to use asset allocation How it works and why Asset allocation = Combining different asset classes to help reduce risk but without necessarily reducing your potential for reward
- 8. Page CC0000.085.0205The Risks Are Real, Let’s Understand them (Total Returns) Source of chart data: Standard & Poor’s Micropal Inc. Stocks are represented by the S&P 500 Index, a widely used measure of U.S. stock market performance. Bonds are represented by the Lehman 30-Year Treasury Bellwether Index. Indices include reinvestment of income, but not transaction costs or taxes, are unmanaged and cannot be purchased directly by investors. This chart is for illustrative purposes only and does not predict or depict the performance of any investment or fund. Past performance does not guarantee future results. Stocks and bonds are subject to different risks. Stocks are different from fixed income securities in that bonds, if held to maturity, may offer both a fixed rate of return and fixed principal value. Fixed income investing entails credit risk and interest rate risk. When interest rates rise, bond prices generally fall.
- 9. Page CC0000.085.0205Volatility Can Be Costly Source of chart data: Ned Davis Research, Inc. Performance represented by hypothetical data. This chart is for illustrative purposes only and does not predict or depict the performance of any investment or index. $110 $110 $121 $121 $133 $133 $120 $146 Volatile Steady 10% $161 $161
- 10. Page CC0000.085.0205Asset Allocation Determines Variance in Returns Source of chart data: Based on the study by Gary P. Brinson, Randolph L. Hood, and Gilbert L. Beebower, “Determinants of Portfolio Performance,” Financial Analysts Journal, January/February 1995. The study analyzed data from 91 large corporate pension plans with assets of at least $100 million. Source: Terrance Odean, “Do Investors Trade Too Much?,” July 1997. Timing the Market and Other 4% Asset Allocation 93% Security Selection 3%
- 11. Page CC0000.085.0205If You Start With $100,000... Conclusion: Limiting volatility may increase returns Source of chart data: Ned Davis Research. Portfolio performance based on hypothetical data. This chart is for illustrative purposes only and does not predict or depict the performance of any investment or index. Asset Allocation and diversification does not protect against losses in declining markets.
- 12. Page CC0000.085.0205Why Asset Allocation? Manage portfolio volatility. Increase potential returns. Mitigate common decision-making errors.
- 13. Page CC0000.085.0205Investments Did Well, Investors Not So Well (Average Annual Returns 1984-2003) Sources of chart data: Dalbar, Inc., Quantitative Analysis of Investor Behavior, July 2004 update. Hypothetical Equity Fund Market Timer
- 14. Page CC0000.085.0205How We Make Investment Decisions The disposition effect refers to people’s tendency to: Hang on to losers Sell the winners Allows us to enjoy the feeling of winning and defer the pain of loss
- 15. Page CC0000.085.0205Which Would You Choose? 80% chance to win $5000, and 20% chance to lose $1000 or 10% chance to win $5000, and 90% chance to lose nothing This is known as “narrow framing”, the tendency to make decisions using relatively narrow frames of reference.
- 16. Page CC0000.085.0205How We Make Investment Decisions To avoid losses, we may engage in: Narrow framing Disposition effect Other behaviors that may undermine investment success: Mental accounting Herding
- 17. Page CC0000.085.0205Asset Allocation: The Anti-Timing Tool Seeks to limit short-term portfolio losses Bases sales decision on need to stay on target Focuses on “big picture,” the goal of achieving overall wealth Uses sophisticated quantitative diversification techniques
- 18. Page CC0000.085.0205Every Asset Class Is Positive Over Time… Average Annual Total Return, 1928-2004 Source of chart data: Ned Davis Research, as of 12/31/04. Stocks are represented by the S&P 500 Index, a widely used measure of U.S. stock market performance, bonds by the Ibbotson Long-Term Government Bond Index and cash by the 91-day Treasury Bill Index. Indices include reinvestment of income, but not transaction costs or taxes, are unmanaged and cannot be purchased directly by investors. This chart is for illustrative purposes only and does not predict or depict the performance of any investment or fund. Past performance does not guarantee future results. Stocks and bonds are subject to different risks. Stocks are different from fixed income securities in that bonds, if held to maturity, may offer both a fixed rate of return and fixed principal value. Fixed income investing entails credit risk and interest rate risk. When interest rates rise, bond prices generally fall.
- 19. Page CC0000.085.0205Source of chart data: Ned Davis Research, as of 12/31/04. Stocks are represented by the S&P 500 Index, a widely used measure of U.S. stock market performance. Bonds are represented by the Ibbotson Long-Term Government Bond Index. Indices include reinvestment of income, but not transaction costs or taxes, are unmanaged and cannot be purchased directly by investors. This chart is for illustrative purposes only and does not predict or depict the performance of any investment or fund. Past performance does not guarantee future results. Stocks and bonds are subject to different risks. Stocks are different from fixed income securities in that bonds, if held to maturity, may offer both a fixed rate of return and fixed principal value. Fixed income investing entails credit risk and interest rate risk. When interest rates rise, bond prices generally fall. … But Has Volatility… 396 days 104 days Average duration -13.5% 11 5.4% Bonds Average decline No. of 10%+ downturns Average annual total return 1928 - 2004 -19.4% 87 10.1% Stocks
- 20. Page CC0000.085.0205Source of chart data: Standard & Poor’s Micropal Inc., as of 12/31/04. Stocks are represented by the S&P 500 Index, a widely used measure of U.S. stock market performance. Bonds are represented by the Lehman Aggregate Bond Index. Indices include reinvestment of income, but not transaction costs or taxes, are unmanaged and cannot be purchased directly by investors. This chart is for illustrative purposes only and does not predict or depict the performance of any investment or fund. Past performance does not guarantee future results. Stocks and bonds are subject to different risks. Stocks are different from fixed income securities in that bonds, if held to maturity, may offer both a fixed rate of return and fixed principal value. Fixed income investing entails credit risk and interest rate risk. When interest rates rise, bond prices generally fall. And Its Own Timing 10.3% 2002 8.4% 2001 11.6% 2000 9.0% 1990 21.0% 1999 6.3% 1981 1.3% Stocks had positive results 1994 When bonds fell 3.0% Bonds had positive results 1997 When stocks fell
- 21. Page CC0000.085.0205Source of chart data: Standard & Poor’s Micropal Inc. For 10 years ended 12/31/04. Stocks are represented by the S&P 500 Index, a widely used measure of U.S. stock market performance, bonds by the Lehman 10-Year Treasury Bellwether Index and cash by a 91-day Treasury Bill Index. Treasury indices are total return indices held at constant maturities. Indices include reinvestment of income, but not transaction costs or taxes, are unmanaged and cannot be purchased directly by investors. This chart is for illustrative purposes only and does not predict or depict the performance of any investment or fund. Past performance does not guarantee future results. Stocks and bonds are subject to different risks. Stocks are different from fixed income securities in that (i) Government bonds and Treasury notes and bills are backed by the full faith and credit of the U.S. Government and (ii) bonds, if held to maturity, may offer both a fixed rate of return and fixed principal value. Fixed income investing entails credit risk and interest rate risk. When interest rates rise, bond prices generally fall. Fact: Asset Classes Move Independently Major Asset Class Correlations (1995-2004) 1.00 Cash 0.24 1.00 Bonds 0.30 Cash -0.03 Bonds 1.00 Stocks Stocks
- 22. Page CC0000.085.0205Combine Asset Classes for Smoother Results Source of chart data: Standard & Poor’s Micropal Inc., as of 12/31/04. Stocks are represented by the S&P 500 Index, a widely used measure of U.S. stock market performance. Bonds are represented by the Lehman Aggregate Bond Index. Indices include reinvestment of income, but not transaction costs or taxes, are unmanaged and cannot be purchased directly by investors. This chart is for illustrative purposes only and does not predict or depict the performance of any investment or fund. Past performance does not guarantee future results. Stocks and bonds are subject to different risks. Stocks are different from fixed income securities in that bonds, if held to maturity, may offer both a fixed rate of return and fixed principal value. Fixed income investing entails credit risk and interest rate risk. When interest rates rise, bond prices generally fall.
- 23. Page CC0000.085.0205Different Times, Different Styles Growth vs. Value (Annual Returns 1995–2006) Source of chart data: Standard and Poor’s Micropal Inc., 12/31/04. Growth performance is represented by the S&P BARRA Growth Index. Value performance is represented by the S&P BARRA Value Index. There are special risks in both styles: with growth investments, there is the possibility of increased volatility; with value investing, there is the possibility that the market may not recognize a stock as undervalued and might not appreciate as expected. The indices are unmanaged, includes reinvested income and cannot be purchased directly by investors. This chart is for illustrative purposes only and does not predict or depict the performance of any investment or fund. Past performance does not guarantee future results. 50% 0 – 30 – 20 – 10 10 20 30 40
- 24. Page CC0000.085.0205Different Times, Different Market Segments Small Cap vs. Mid Cap vs. Large Cap (Annual Returns 1995–2006) Source of chart data: Standard and Poor’s Micropal Inc., 12/31/04. Large-cap stocks are represented by the S&P 500 Index, a broad-based index of domestic stocks; mid-cap stocks are represented by the S&P MidCap 400 Index; small-cap stocks are represented by the Russell 2000 Index. Small-cap stocks may be subject to greater volatility than mid-cap or large-cap stocks. The indices are unmanaged, include reinvested income and cannot be purchased directly by investors. This chart is for illustrative purposes only and does not predict or depict the performance of any investment or fund. Past performance does not guarantee future results. 50% 0 – 30 – 20 – 10 10 20 30 40
- 25. Page CC0000.085.0205Adding Asset Classes May Enhance Your Returns Source of chart data: Standard & Poor’s Micropal Inc. Large-cap stocks are represented by the S&P 500 Index; mid-cap stocks by the S&P MidCap 400 Index; small-cap stocks by the Russell 2000 Index; foreign stocks by the MSCI EAFE Index; short-, intermediate- and long-term bonds by the Lehman 1-3 year Government, 5-year Treasury and 10-year Treasury Indices, respectively; cash by the 91-day Treasury Bill Index. Treasury indices are total return indices held at constant maturities. Indices include reinvestment of income, but not transaction costs or taxes, are unmanaged and cannot be purchased directly by investors. This chart is for illustrative purposes only and does not predict or depict the performance of any investment or fund. Past performance does not guarantee future results. Stocks and bonds are subject to different risks. Stocks are different from fixed income securities in that (i) Government bonds and Treasury notes and bills are backed by the full faith and credit of the U.S. Government and (ii) bonds, If held to maturity, may offer both a fixed rate of return and fixed principal value. Fixed income investing entails credit risk and Interest rate risk. When interest rates rise, bond prices generally fall. Cash Long-term Bonds Short-term Bonds Intermediate Bonds Large-cap Stocks Mid-cap Stocks Foreign Stocks Small-cap Stocks 2003 Foreign Stocks Large-cap Stocks Small-cap Stocks Cash Short-term Bonds Intermediate Bonds Long-term Bonds Mid-cap Stocks 2000 Foreign Stocks Large-cap Stocks Mid-cap Stocks Small-cap Stocks Cash Long-term Bonds Intermediate Bonds Short-term Bonds 2001 Large-cap Stocks Small-cap Stocks Foreign Stocks Mid-cap Stocks Cash Short-term Bonds Intermediate Bonds Long-term Bonds 2002 Short-term Bonds Best Performing Worst Performing Cash Intermediate Bonds Long-term Bonds Large-cap Stocks Mid-cap Stocks Small-cap Stocks Foreign Stocks 2004
- 26. Page CC0000.085.0205Asset Allocation: Picking Your Mix Which is the correct asset allocation? Stocks 60% Bonds 30% Cash 10% Stocks 20% Bonds 60% Cash 20%
- 27. Page CC0000.085.0205Is there Risk in All Portfolios? Two Portfolios with the same Stock/Bond Allocation could have completely different risks. One may have higher growth stocks while the other focuses on Value or a certain sector. Bond classes have different risk levels as well.
- 28. Page CC0000.085.0205Combinations for Different Risk/Reward Profiles The Efficient Frontier, Stocks and Bonds (1980-2004) Source of chart data: Standard & Poor’s Micropal Inc., for 25 years ended 12/31/04. Stocks are represented by the S&P 500 Index, a widely used measure of U.S. stock market performance. Bonds are represented by the Lehman Aggregate Bond Index. Indices include reinvestment of income, but not transaction costs or taxes, are unmanaged and cannot be purchased directly by investors. This chart is for illustrative purposes only and does not predict or depict the performance of any investment or fund. Past performance does not guarantee future results. Stocks and bonds are subject to different risks. Stocks are different from fixed income securities in that bonds, If held to maturity, may offer both a fixed rate of return and fixed principal value. Fixed income investing entails credit risk and Interest rate risk. When interest rates rise, bond prices generally fall. 100% Stocks 50% Stocks 50% Bonds 100% Bonds
- 29. Page CC0000.085.0205Asset Allocation Mix Choices: Source of chart data: Standard & Poor’s Micropal Inc. Stocks are represented by the S&P 500 Index, a widely used measure of U.S. stock market performance. Bonds are represented by the Lehman Aggregate Bond Index. Indices include reinvestment of income, but not transaction costs or taxes, are unmanaged and cannot be purchased directly by investors. This chart is for illustrative purposes only and does not predict or depict the performance of any investment or fund. Past performance does not guarantee future results. Stocks and bonds are subject to different risks. Stocks are different from fixed income securities in that bonds, If held to maturity, may offer both a fixed rate of return and fixed principal value. Fixed income investing entails credit risk and Interest rate risk. When interest rates rise, bond prices generally fall. Notes/Bonds Return 7% 7.0 7.0 7.0 7.0 7.0 100 0 4.3 5.3 6.3 7.3 8.3 90 10 1.6 3.6 5.6 7.6 9.6 80 20 – 1.1 1.9 4.9 7.9 10.9 70 30 – 3.8 0.2 4.2 8.2 12.2 60 40 – 6.5 – 1.5 3.5 8.5 13.5 50 50 – 9.2 – 3.2 2.8 8.8 14.8 40 60 – 11.9 – 4.9 2.1 9.1 16.1 30 70 – 14.6 – 6.6 1.4 9.4 17.4 20 80 – 17.3 – 8.3 0.7 9.7 18.7 10 90 If the total return on stocks is: PORTFOLIO MIX (%) – 20% – 10% 0% 10% 20% – 20.0% – 10.0% 0.0% 10.0% 0% Bonds 20.0% The weighted average return on the portfolio is: 100% Stocks
- 30. Page CC0000.085.0205Keep your Investments in Shape Your portfolio can become overly risky with time Rebalancing may help shed some risk Keep your Investments in Shape CC0000.024.0304 March 15, 2004 Jan. 1970 to Dec. 2004 Jan. 1980 to Dec. 2004 Jan. 1990 to Dec. 2004 12.8% 10.4% 10.1% 12.7% 9.4% 11.1% 11.0% 11.3% 11.7% 12.1% 8.8% 9.4% Your portfolio can become overly risky with time Rebalancing may help shed some risk Risk Return Rebalanced portfolio Not rebalanced portfolio
- 31. Page CC0000.085.0205Know who is Managing Your Money… You should ask: Does the manager have his/her own money invested in the fund? Does the manager have at least five years experience? Do those years include a bear market? I can answer, “yes” to each question! 95% of my long-term assets are invested right with yours!
- 32. Page CC0000.085.0205Implement Your Plan You will need access to: Someone who understands your plan and is going to give you first class advice. You do not have to pay commissions to get this! A First-class money manager. Investments that are true to their designated roles
- 33. Page CC0000.085.0205Maintain Your Plan’s Integrity Set up your plan and live by it, just like brushing your teeth every morning. If you don’t brush, you know the outcome! Maintain tactical rebalancing or invest in a vehicle that does it for you. Update/revise to reflect changing goals and personal circumstances as needed. College Second Home
- 34. Page CC0000.085.0205Implementing a Successful Plan with The Archer Funds. Experienced, professional investment manager Historically competitive total returns Reduced Risk (beta)
- 35. Page CC0000.085.0205By working with The Archer Funds, I will assist you to: Develop your plan Define your goals Manage your money Monitor your progress
- 36. Page CC0000.085.0205Asset Allocation: One Way to a Successful Investment Plan Maintain a long-term horizon Understand your tolerance for risk Save on a regular basis Plan well and review your decisions
- 37. Are you managingyour asset allocation? The Archer Balanced Fund, a no-load fund, will at all times maintain an asset allocation model by investing in stocks and bonds at various percentages. Within the stock and bond portfolio, the Fund will be further allocated among asset classes such as pharmaceuticals, financials, utilities, short- and long-term notes and bonds. These allocations will be managed with the goal of enhancing the Fund’s total return while keeping the risk, or volatility of the Fund, below that of the broader market.
- 38. Page CC0000.085.0205Thank You Past performance does not guarantee future results. Due to ongoing market volatility, current performance may be more or less than the results shown in this presentation. For performance data of The Archer Funds current to the most recent month end, visit us at www.archerbalancedfund.com or call us at 1.800.671.5872. The performance information shown in this presentation does not show the effects of income taxes on an individual’s investment. Taxes may reduce your actual investment returns or any gains you may realize if you sell your investment. An investor’s shares, when redeemed, may be worth more or less than the original cost. Shares of The Archer Funds are not deposits or obligations of any bank, are not guaranteed by any bank, are not insured by the FDIC or any other agency, and involve investment risks, including the possible loss of the principal amount invested. You should carefully consider the investment objectives, potential risks, management fees, and charges and expenses of the Fund before investing. The Fund’s prospectus contains this and other information about the Fund, and should be read carefully before investing. You may obtain a current copy of the Fund’s prospectus by calling 1-800-238-7701 or by visiting www.thearcherfunds.com . Past performance is no guarantee of future results. Your fund shares, when redeemed, may be worth more or less than their original cost. Distributed by Unified Financial Services, Inc. Member NASD 431 North Pennsylvania Street P.O. Box 6110 Indianapolis, IN 46204 Indianapolis, IN 46206-6110 (800) 238-7701
- 39. Page CC0000.085.0205 February 15, 2005 Q & A A Guide to Asset Allocation The Archer Funds
Editor's Notes
- #2 Thank you for allowing me time to discuss Archer Investment Corporation, the investment manager to the Archer Balanced Fund. This presentation will last about 30 minutes and will inform you not only about money and the markets, but also about asset allocation.
- #3 We would like to take the puzzle out of investing and asset allocation. The markets can be puzzling if we don’t understand the basics about the market and what has traditionally moved the markets in all directions.
- #4 In order to understand investing, you have to first understand money. In order to understand today’s investing markets, you need to first understand the last 50 years, which set the background for today’s market. The primary driver of major market changes in our opinion has been inflation and what it has done to our money. Let’s start with that.
- #5 As you can see from the slide, inflation has changed in varying directions for the last 80 years. We use this as a guide for estimating what inflation will do in the future and as a guide as to how the markets may react given differing degrees of inflation.
- #6 It is interesting when you place an overlap of the 10 year treasury bond over the P/E of stocks (explanation of P/E) and see an inverse relationship of Treasury bond prices to the median vs. the P/E of companies to the Median.
- #7 This all leads to the basic question of how to invest given varying circumstances in the market. Lets talk about a valuable tool for building an investment portfolio that may make it easier to meet your investment objectives. That tool is asset allocation.
- #8 You may have heard of asset allocation, but just to be sure we are all on the same page, I will give you a quick definition. Then, I’d like to tell you three compelling reasons why you should use it in your portfolio. I will explain how it works, and why. And I will introduce you to several ways that you might develop your own personalized asset allocation strategy. Now, that definition… . Asset allocation is the science of combining different types of investments so that you can achieve the most reward for the amount of risk you are willing to assume. Put another way, it’s a technique for limiting the risk in your portfolio, but without a commensurate reduction in your potential for reward.
- #9 Of course, to manage risk, we must understand what it is. What does the word “risk” mean to you? To many people, “risk” is synonymous with the possibility of losing money. The more likely an investment is to lose money from time to time, the greater the risk. We refer to this idea of inconsistent investment returns as volatility. You may have heard it explained this way: When an investment gains 100%, we call it growth; and when it loses 50%, we call it volatility. It’s common to associate risk or volatility with stocks. But volatility is a very real phenomenon for all investments. In 2000-2002, as measured by the S&P 500, U.S. stocks lost 37% of their value. Bonds are also prone to volatility—in 1999 the 30-year Treasury was down almost 15%--and that assumes reinvested income. The bottom line: No matter what you invest in, you cannot avoid volatility. You can, however, manage it intelligently, so that you limit its impact on your portfolio’s performance.
- #10 Why is controlling or limiting volatility’s impact on a portfolio so important? Because losses are more costly to performance than people may realize. Here’s a simple example. If an investor could consistently earn 10% per year on a hypothetical investment and reinvests the earnings, the investment will grow to $161 after five years. You can see the progression in the [green] row of numbers at the bottom of the slide. Now imagine the investor achieves the 10%-per-year goal for three years, then experiences a 10% loss in Year 4. That’s what you see in the bar chart and the bottom row of [purple] numbers. What kind of return do you think it will take in Year 5 to get the investor back on track, so that at the end of Year 5 he has $161? The answer is: The investor needs a 34.4% return in Year 5. The investor needs to triple his return for at least a year or risk falling behind. The chances of achieving such a robust return in a single year are relatively slim. More likely, it will take several years to recover from this one-year loss. Asset allocation aims to control this kind of year-to-year volatility, and that’s the first reason to make good use of it.
- #11 In fact, studies show that about 93% of the variance in portfolio returns from year to year – or what we call volatility – historically has been determined by the asset allocation of a portfolio. It’s bar none the single most important factor in managing portfolio volatility.
- #12 When managing risk, it can also be useful to control the degree of volatility. Consider this example. A portfolio that fluctuates by 10% in each direction for two years ends up at $99,000. One that fluctuates by 20% winds up worth $96,000. By the way, it doesn’t matter whether the negative year comes first or second. The bottom line: It may literally pay in dollars and cents to limit the volatility of your investment. That’s the second reason to implement an asset allocation strategy: by limiting volatility, asset allocation may increase your total returns over time.
- #13 Using asset allocation can also help you overcome what can be a substantial handicap for individual investors: a tendency toward not-so-rational decision-making. Let’s look how investors’ decision-making may affect a portfolio for the worse.
- #14 Dalbar Financial Services, a consulting firm, studies how mutual fund investors’ behavior affects the returns that they actually earn. Here's what Dalbar found in their latest report based on data from January 1984 through December 2003: Stocks, represented by the S&P 500 Index, returned almost 13% on an average annual basis during that period, while the average equity fund investor earned an unimpressive 3.51% average annual rate of return. The market timing equity fund investor fared even worse with a –3.29% return. As you can see, chasing performance and trying to time the market can really hurt returns.
- #15 Are you wondering how can investors generate such poor results? A big part of the answer is: timing the market. The S&P 500 Index was, by definition, fully invested the whole time. The investors, in comparison, generally went in and out of the stock market. That in and of itself wouldn’t be a problem; too often, however, investors may buy and sell at less-than-optimal times, and based on dubious reasoning. One example of this poor decision-making is known as “the disposition effect.” Imagine this: An investor has two investments, each made two years ago. Since then, one of the investments has lost 15%; the other is ahead by 20%. Now, the investor decides to sell the “winner” and hang on to the “loser.” Sound preposterous? Not when you consider that most of us are very uncomfortable with risk or, more specifically, losses. From that standpoint, it may make sense. By selling an investment at a gain, it becomes a winner, and we experience the pleasure associated with a “good” investment. Hanging on to losers lets us defer the pain associated with incurring a loss. We can then indulge in the belief the investment may bounce back and become a winner.
- #16 Let me give you another example of interesting reasoning. Which of these options would you choose? The first provides a much greater chance of getting ahead, yet most people choose the second option. Why? Because they want the certainty of not losing. So, a majority of people select the relative certainty of the second option. This is known as “narrow framing,” referring to the tendency to make decisions using relatively narrow frames of reference.
- #17 You’ve just experienced firsthand a major factor in investor behavior: To a greater or lesser degree, nearly all of us have an aversion to losses. We’ll take some interesting mental steps to deal with that aversion. The disposition effect and narrow framing are just two of those loss-avoidance techniques. Another reason we may make questionable or poorly timed investment decisions is known as “mental accounting.” This is the tendency to, mentally, divide our money into different categories. This allows us to segregate “winners” from “losers” and feel good about the former. But we lose sight of the big picture – namely, our overall progress toward building wealth. Naive diversification can also be a problem. This may happen when our choices about how to diversify are driven not by their own risk/reward profiles and investment goals but by the investment options available. Finally, there is herding. Who hasn’t heard of the idea of following the crowd – sometime, right over the proverbial investment cliff?
- #18 In my view, asset allocation is an antidote to such questionable decision-making and the poor market timing that may result. Asset allocation aims to control volatility – that is, the amount and frequency of losses. Thus, it addresses our loss aversion and reduces the need to engage in tricky mental investment games like narrow framing. When you use an asset allocation strategy, sales decisions are based on how the disposition will help you stay on target toward your long-term goal. Goodbye, “disposition effect.” Asset allocation considers all your investment goals – and how, over time, to build and maintain the wealth needed to meet all of them. So long, mental accounting. Finally, assets allocation chooses your diversification strategy based on your criteria and goals, not on the basis of “what’s available.” If you have aggressive goals, it will give you an aggressive combination of assets. Beyond that, it uses sophisticated, quantitative analysis to help you do choose the investments that will give you the desired diversification. Now, let’s look at how asset allocation works.
- #19 Broadly speaking, there are three asset classes: stocks, bonds and cash. Here we can see that, since 1928, all three have delivered positive long-term total returns. You can also see that stocks have outperformed both bonds and cash, averaging a 10.1% annual total return. Over the same time period, long-term Treasury bonds returned 5.4% and cash, measured by 90-day Treasury bills, returned 3.9%. At first glance, stocks are the place to be if you want to build wealth over time. But, as we all know, the ride can sometimes be very bumpy. Note: Stocks offer long-term growth potential but may fluctuate more and provide less current income than other investments.
- #20 Since 1928, stocks have suffered 87 downturns of 10% or more. The average length of these corrections has been 3.4 months; and the average decline, 19.4% The phenomenon is not limited to stocks, however. Bonds, too, experience down markets. They are less frequent and less severe – the average decline is 13.5% – but they last longer on average – well over a year.
- #21 Fortunately, stocks and bonds almost never endure downturns at the same time. Since the Vietnam War ended, there have been six years when stocks lost money. Bonds performed positively in those same years. Likewise, in the two years since 1975 when bonds delivered negative returns, stocks were positive. The conclusion: Different asset classes not only deliver different levels of risk and return. They do so at different times, one advancing while another retreats.
- #22 By looking at the historical patterns for different classes, we can estimate how often and to what extent they will move together or in opposition. This is known as the correlation between asset classes. The higher the correlation, the more often two asset classes move in similar ways, at similar times. Here you can see the correlations of the three major asset classes: stocks, bonds and cash. Look at the number in the bottom row, on the left. That 0.30 tells us that stocks and cash rise or fall in unison about 30% of the time. The -0.03 above it tells us that stocks and bonds have a negative correlation which means, for this time period, stock and bonds tended to move in opposite directions.
- #23 Asset allocation uses this information about correlations, to put together portfolios that may limit volatility. The key is to create combinations that are not highly correlated – that is, asset mixes that are likely to balance losses in one asset class with gains from another. This balancing act may smooth out results from year to year and reduce the possibility of losses. In this hypothetical example, half the portfolio is invested in stocks; the other half, in bonds. Since these groups rarely move up and down in unison – with a -0.03 correlation – their movements balance each other out, to give a result that is less volatile from year to year. What does that really mean, other than the fact you might sleep better at night? First, remember our example of the portfolio that lost 10% in just one year? It needed a 34% return thereafter to get back on track. If you have no loss, fewer losses or just more consistent returns, your portfolio doesn’t have to work as hard to make up for down years. Thus, you may not have to invest as aggressively to get to the same place in the end. Second, you’ll recall the example of the two portfolios that fluctuated by 10% and 20%. The portfolio with less volatility came out ahead, with the higher total return.
- #24 Do any of you own more than one stock fund? Does anyone own a growth fund and a value fund? Then you may know from personal experience that what’s true for stocks and bonds is also true within those asset classes. Different groups within an asset class do not necessarily move in lockstep, either. As this chart shows: • Growth stocks led the market higher for most of the ’90s. • But there were several times since the year 2000 in which value stocks outperformed growth stocks. This chart could just as easily have compared corporate bonds to government or high-yield bonds. We would have found the same situation: a trading off of market leadership from time to time.
- #25 Within the equity markets, size matters as well. Different sized companies tend to prosper at different times in the economic cycle. It is quite common to see small-company stocks perform strongly in the earlier phases of an economic recovery. Later, as the recovery matures, large-company stocks have generally taken the lead. For bonds, different maturities will lead or lag as the economic cycle and interest rates change.
- #26 More than that, adding asset classes may help to increase your returns. Why? Because by adding asset classes you increase the chance that in any given year, part of your portfolio will be invested in the best-performing asset group. As this table shows, no single asset class dominates each year; different asset classes take turns as market leaders and, for that matter, as laggards. Look at 2000 and 2001’s worst-performing asset class, foreign stocks. They were the best-performing asset class in 2004. This kind of rotation from top to bottom and back again is not, however, limited to foreign stocks. If you study the chart for a minute, you’ll see that plenty of other asset classes to it as well. It’s all the more reason to diversify through asset allocation and increase the likelihood of having a winning asset class in your portfolio at all times.
- #27 The question now is: Which mix is the right asset allocation? How do you know which allocation has a lower risk tolerance. The mere asset classes do not tell the entire story. In fact, you could invest in bonds which have more risk. Especially if you are investing in bond funds that buy and sell continuously. You could be taking risk in Cash at certain times of rising interest rates.
- #28 The right mix will be the one that comes closest to achieving two objectives: A level of volatility you can comfortably accept and The total return you desire. In reality, there can be as many appropriate asset allocations are there are people who need them. That’s the beauty of asset allocation; it can be tailored to you.
- #29 Every dot on this chart represents the return and risk/volatility of a different combination of stocks and bonds. The combinations range from 100% bonds/0% stocks on the bottom left to the opposite, 100% stocks/0% bonds, on the top right. This chart is based on actual performance history for the S&P 500 Index of large-cap stocks and the Lehman Brothers Aggregate Bond Index for the past 25 years (1980-2004). Notice that the combination of 90% bonds/10% stocks had less volatility than a pure-bond portfolio (6.08% vs. 6.17%) but delivered a better total return (10.07% vs. 9.57%). Once again, asset allocation may reduce risk without reducing your potential for total return. In fact, it may actually increase it. Note that bonds are subject to interest rate risk and, as interest rates rise, bond prices generally fall. We call the line represented by these dots “the efficient frontier.” The points along this line show the best return that could have been achieved for any particular level of risk or volatility, using these two asset classes. I could construct an efficient frontier for almost any combination of asset classes – say, mid-cap stocks, long-term bonds and foreign stocks. Which brings me to my next point…
- #30 Once you have identified your risk/reward profile, you need to select a combination of asset classes that fits the profile. Here’s a hypothetical example of how you might do that. The two columns on the left show multiple combinations of stocks and bonds. We assume bonds will earn 7%. Then we consider the impact on the overall portfolio if stocks rise or fall 20%, rise or fall 10%, or remain unchanged. For instance, for a portfolio comprising 90% stocks/10% bonds, a 10% decline in the stock market would give an overall portfolio return of -8.3%. Let’s say you are prepared to accept an overall decline of 10% if the stock market declines 20%. A mix of approximately 60% stocks and 40% bonds might work for you. The projected loss when the stock market declines 20% is 9.2%. Of course, when stocks are rising, this 60/40 combination will typically return less than the stock market. Over time, though, if the stock market were to achieve its long-term historical average of 10%, this asset allocation could deliver a 8.8% average annual total return. You may have noted something in how I used this chart: I focused on the question of how much short-term loss or volatility is acceptable. Why? Because asset allocation is not about deciding how much to invest in stocks. It’s about finding the best return you can for the amount of volatility you are willing to assume. When you take this this approach, you’ll probably have a more comfortable investment experience overall.
- #31 Keeping your investments in shape is a small task, but one that gets overlooked often times. Lets go through the following example.
- #32 You need to understand who is managing your money.
- #33 You’ll want to implement your plan with appropriate investments in each asset category. I suggest that you look for: Access to the full range of asset classes. You don’t want a narrow range of investment choices to effectively dictate your asset allocation, resulting in naïve diversification. Mutual funds can be a sensible way to build a plan. Funds are available in every asset class. Beyond that, funds can offer broad diversification within a single asset class. Style-consistent funds, meaning funds that stay focused where they say they will. Consider this example: You decide you want a large-cap fund as part of your strategy. You choose one, only to have the manager begin investing in mid-cap stocks, which tend to be more volatile than large caps. The manager’s decision to drift out of the fund’s stated niche will likely affect the overall risk level of your portfolio. The bottom line: Funds that stay within their stated parameters are key to a strategy that stays on target.
- #34 Monitoring style drift to maintain your plan’s integrity is just one reason to review your strategy regularly. I believe it’s also another good reason to seek assistance from a professional financial advisor. Here are some other areas an advisor can help you monitor: Market-induced changes to your allocation. When the stocks, bonds or some other portion of your portfolio grow faster than expected, your allocation to that asset class can become larger than you anticipated or intended. That also means your exposure to risk is not what you intended. Should you reposition assets to bring your asset allocation back into line and, if so, how? A professional can help you find that answer. Near-term opportunities. Asset allocation is a long-term, goal-based strategy. Nonetheless, there may be periods when it’s obvious the economic cycle will favor one asset class over another. The question is: Should you make a short-term shift in your allocation to capture that opportunity? Again, an advisor can help you explore the ramifications, for better and worse, of such a tactical move. Changing personal circumstances and goals. A major life change can shift your priorities and timeframes. An advisor can help you figure out how to alter your plan to keep up with your changing life.
- #35 There are several ways to create and maintain a personalized strategy. I have already alluded to the potential benefits of working with a financial advisor to create, implement and maintain your plan. Whether you devise your plan independently or work with an advisor, it’s important to select funds from a first-class investment management group. One such company is OppenheimerFunds. It's one of several leading firms that have asset management expertise in a broad range of markets – stocks, bonds, foreign securities, commodities and even hedge funds. OppenheimerFunds was founded in 1960, so it’s not new to the business of investing. Historically, its funds have had competitive returns across all the major investment categories.
- #36 There are four essential points in any investment plan.
- #37 We end with some basic rules about investing: 1) Keep your eyes down the road. In the short-run this is difficult since we are all assailed by headlines and “hot” news. However, a long-term perspective is essential for long run success. 2) Don't pay lip service to risk. Don't think you won't mind if your assets go down a lot because you will “make it back up.” You will mind—a lot. Understand how much risk you want to take so you will not abandon your path during times of uncertainty. 3) There is no such thing as a sure thing. Diversify your assets. Asset allocation addresses all three of these rules. 4) Have a regular savings program. Don't wait for "good" times to save. You may decide to buy a car instead. 5) There is a fifth rule: People do not go on vacation by showing up at the airport and selecting a flight off the departure screen. They plan ahead. Most people spend more time planning a one week vacation than for retirement. So rule five is: Spend some time thinking about the first four rules.
- #39 Thank you. Hand out this slide.