How To Build A Portfolio

10/3/2011


Q Over time, stocks generally earn higher returns than bonds. So why should I own bonds?
A From 1926 through 2010, large-company stocks generated an annualized return of 9.9%, versus 5.5% for long-term government bonds. But bonds delivered slightly higher risk-adjusted returns, as measured by the information ratio (average annual return divided by the standard deviation of returns, a measure of volatility).

Investors who would like to limit their risk — without giving up the superior return potential of equities — can hedge their bets by blending stocks and bonds, as shown below. Adding bonds to an all-stock portfolio can lower volatility substantially without a commensurate decrease in return, as stock and bond returns often follow different paths.

Based on the information ratio, a portfolio with 30% large-company stocks and 70% long-term government bonds provided the highest risk-adjusted returns from 1926 through 2010. But for investors seeking returns closer to those of stocks, even a 10% or 30% bond position can substantially decrease volatility and still deliver solid total returns.

Q How much do I invest in stocks, versus fixed-income?
A If there was a simple equation that worked for everyone, the Forecasts would present it. However, many factors come into play when determining the best asset allocation.

As a starting point, consider this rule of thumb: Subtract your age from 110 to find the percentage of your portfolio to invest in stocks. Younger investors have more time to make investments, and that gives them a greater ability to ride out the volatility that comes with stocks. But age is just one piece of the asset-allocation puzzle. Below we present six additional factors to consider.

Wealth. An 80-year-old with a $5 million portfolio can probably afford a higher stock allocation than a 60-year-old with $100,000 because the younger man has less ability to absorb the loss of what wealth he already has.

Risk tolerance. Investments are supposed to enrich you, not worry you sick. If you tend to fret about market fluctuations, you might be happier with a higher bond allocation than your financial situation would otherwise demand.

Lifestyle. Suppose you have $1 million and expect to live 20 more years. If you wish to draw out $50,000 this year and boost the payment by 5% a year to cope with inflation, you need a 5% return. If instead your lifestyle requires $80,000 a year to start, you'll need 11% returns to cover 20 years of expenses.

Future liquidity. If you will need a lump sum in the next 10 years, you may want to emphasize less-volatile investments. This limits your risk of having to sell at the wrong time.

Time horizons. The longer the period you can invest, the more risk you can afford to take. A man in his 50s with a serious health problem may require a higher-than-normal bond allocation. In contrast, an elderly woman living on a pension who intends to leave her wealth to children or to a charity can take a longer view.

Your view of the market. Once you set your long-range allocation, leave room for tactical adjustments based on your return expectations. If you want to follow our current advice, hold about 22% of the portion of your portfolio designated to equities for the long haul in a short-term bond fund as a partial hedge. While we don't think timing the market in an all-or-nothing way makes sense, we will hold up to 40% of our equity portfolios in short-term reserves if we think stocks are trending lower.

The six factors presented above are some of the most common asset-allocation considerations, but far from a complete list. Consider your per-sonal situation before making asset-allocation decisions. For additional help, check out our asset optimizer at www.DowTheory.com/Go/Assets.

Q Alternative assets can generate big returns. Should I own investments other than stocks and bonds?
A The table below provides historical return and volatility data for indexes that reflect several types of alternative investments. Some of these investments (real estate, commodities, and hedge funds) can be difficult to value or trade, and are suitable only for investors willing to put in the time to follow them and learn how they work. Exchange-traded funds that track such assets rely on derivatives and often deliver returns far different from the underlying index. If you seek to invest directly in hedge funds or real estate, consult a financial adviser who knows both the asset classes and your personal financial situation.

ALTERNATIVE ASSETS
Since 1994, hedge funds and real estate have delivered stronger returns than commodities and U.S. or foreign stocks. Real-estate returns somewhat overstate the asset class's relative performance, as they only go through June 30, versus Sept. 27 for the other indexes. However, based on returns through June and annualized quarterly standard deviation, real estate has outperformed every asset class but hedge funds, with lower volatility, as measured by standard deviation.
Index
Annualized
Return
Since 1994
(%)
Annualized
Standard
Deviation
(Monthly
Returns)
(%)
MSCI EAFE Index (Stocks, Developed Foreign Markets)
4.6
16.9
MSCI Emerging Mkts. Index (Stocks, Emerging Mkts.)
5.4
24.4
NCREIF Property Index (Commercial Real Estate)
9.1
NA
CRB Index (Commodities)
1.8
13.9
Dow Jones Credit Suisse Hedge Fund Index 
8.6
7.6
S&P 500 Index
5.3
15.5
Intermediate-Term Government Bonds
6.0
4.6
NA Not Available, return data is quarterly.    Sources: Credit Suisse, NCREIF, MSCI, Morningstar.

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