Portfolio Management

Portfolio Management – Why Is Asset Allocation Important?

The theory behind asset allocation is to spread your investments across different asset classes to help protect your portfolio from downturns in any one asset. Since different investments are affected differently by economic events and market factors, owning different types of investments helps reduce the chances that your portfolio will be adversely affected by a particular risk type. Does asset allocation really accomplish this goal?

To see how asset allocation can help reduce your portfolio's volatility, consider this example. During the period from 1976 to 2005 (30 years), the Standard & Poor's 500 (S&P 500) had an average annual return of 12.7%, while intermediate-term government bonds had an average return of 8.3%. The largest loss sustained in any given year for the S&P 500 was 22.1% in 2002 and 5.1% for intermediate-term bonds in 1994.

The S&P 500 is used as a measure of common stock returns, since it is an unmanaged index generally considered representative of the U.S. stock market. Keep in mind that stocks and government bonds have different investment characteristics.

Stocks can have fluctuating principal and returns based on changing market conditions, while government bonds have fixed principal value and yield if held to maturity and are guaranteed as to the timely payment of principal and interest.

The table below indicates the average annual return and largest one-year loss if varying percentages of these two assets were held:

% owned of S&P 500 % owned of Bonds Average Return Largest Loss

100% 0% 12.7% -22.1%

90 10 12.3 -18.6

80 20 11.8 -15.1

70 30 11.4 -11.6

60 40 10.9 -8.1

50 50 10.5 -4.6

40 60 10.1 -2.5

30 70 9.6 -3.2

20 80 9.2 -3.8

10 90 8.7 -4.5

0 100 8.3 -5.1

To obtain the highest average return, you must invest totally in the highest performing asset, but that asset also has the potential for the greatest loss. The smallest one-year...