Asset Allocation

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Asset Allocation

Post by gbs »

[contributions needed]

If you are just beginning your investment journey and would like to understand what is meant by "asset allocation" and how it fits into the development of a financial plan, the following links should prove helpful.

1. Bill Schultheis: The 3 Principles of Investing
link: here

2. Vanguard: Portfolio model allocations
link: here

The varying nature of asset class performance can be visualized by taking a good look at these periodic tables of investment returns.

Callan Periodic Table of Investment Returns

Janus Periodic Table of Investment Returns

Crowe Periodic Table of Investment Returns
contributed by: CyberBob

Robert T. provides a concise reader on Asset Allocation issues:
Robert T wrote: 10 landmark [easy read] short articles

At least they were landmark to me – hope others find them useful.

One per author with some vague ordering from asset allocation to security selection.
I also have to add these two. The first is the seminal 1993 article by Fama-French (longer and less easy to read), and the other is a ‘how to’ guide on three factor regressions (for those interested).

[contributed by Robert T.]
A related topic involving the placement of asset classes in taxable and tax deferred accounts can be found at Asset Location

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Last edited by gbs on Sat Mar 03, 2007 3:57 pm, edited 1 time in total.
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Post by gbs »


1. The Asset Allocation Question by Richard A. Ferri, CFA
The process of asset allocation begins by putting dollar figures on subjective goals like financial security, a comfortable retirement, and providing for children.
2. Beyond Markowitz: A Comprehensive Wealth Allocation Framework for Individual Investors by Ashvin B. Chhabra
The Wealth Allocation Framework enables individual investors to construct appropriate portfolios using all their assets, such as their home, mortgage, market investments and human capital.
3. Human Capital, Asset Allocation, and Life Insurance by Ibbotson, Roger G., Chen, Peng, Milevsky, M.A. and Zhu, Xingnong
Thus, human capital affects both the optimal asset allocation and the optimal demand for life insurance. Yet historically, asset allocation and life insurance decisions have consistently been analyzed separately both in theory and practice.
4. Lifetime Financial Advice: Human Capital, Asset Allocation, and Insurance by Roger G. Ibbotson, Moshe A. Milevsky, Peng Chen, CFA, and Kevin X. Zhe (2007)
We can generally categorize a person’s life into three financial stages. The first stage is the growing up and getting educated stage. The second stage is the working part of a person’s life, and the final stage is retirement. This monograph focuses on the working and the retirement stages of a person’s life because these are the two stages when an individual is part of the economy and an investor. Even though this monograph is not really about the growing up and getting educated stage, this is a critical stage for everyone. The education and skills that we build over this first stage of our lives not only determine who we are but also provide us with a capacity to earn income or wages for the remainder of our lives. This earning power we call “human capital,” and we define it as the present value of the anticipated earnings over one’s remaining lifetime. The evidence is strong that the amount of education one receives is highly correlated with the present value of earning power. Education can be thought of as an investment in human capital. One focus of this monograph is on how human capital interacts with financial capital. Understanding this interaction helps us to create, manage, protect, bequest, and especially, appropriately consume our financial resources over our lifetimes. In particular, we propose ways to optimally manage our stock, bond, and so on, asset allocations with various types of insurance products. Along the way, we provide models that potentially enable individuals to customize their financial decision making to their own special circumstances.
5. Asset Allocation and Long-Term Returns: An Empirical Approach by Stephen Coggeshall and Guowei Wu
(...)we describe a heuristic, empirical approach that uses concepts of Shortfall Risk as an objective and actual data as a direct model of the stochastic market evolution.
6. Portfolio Performance and Strategic Asset Allocation Across Different Economic Conditions by Sa-Aadu, Jarjisu, Shilling, James D. and Tiwari, Ashish
Our key result is that commodities and precious metals, and equity REITs are the two asset classes that deliver portfolio gains when consumption growth is low and/or volatile, i.e., when investors really care for such benefits. Consistent with these results, our examination of investor portfolio allocations using a regime switching framework reveals that during the 'bad' economic state, the mean-variance optimal risky portfolio is tilted towards equity REITs, precious metals, and Treasury bonds. Our analysis highlights an important metric by which to judge the attractiveness of an asset class in a portfolio context, namely the timeliness of the gains in portfolio performance.
contributed by Barry

7. How to Evaluate a New Diversifier with 10 Simple Questions by Kat, Harry M. (December 2006)
In this paper we discuss a number of important questions to ask when analysing a new alternative diversifier from either a stand-alone, asset-only or asset-liability point of view. The framework is simple, but highly effective. Apart from the new diversifier's statistical properties, it emphasizes the importance of properly accounting for parameter uncertainty and illiquidity; two elements very often ignored by investors. It also shows the importance of taking the correct perspective when evaluating a new diversifier. What looks good from a stand-alone perspective need not look good in a portfolio context and vice versa. Application of the above framework to funds of hedge funds, commodities and synthetic funds underlines the advantages and disadvantages of these diversifiers and clearly points at synthetic funds as the most and funds of hedge funds as the least attractive of the three.
The Ten Questions To Ask

1. What risk premium is offered?
2. How volatile are the returns?
3. Are returns positively or negatively skewed or explicitly floored or capped?
4. How certain are you of the above?
5. How liquid is the investment?
6. Is the fee charged fair in relation to the above?
7. What is the correlation with the existing portfolio?
8. What is the co-skewness with the existing portfolio?
9. What is the correlation with the liabilities?
10. What is the co-skewness with the liabilities?
contributed by Barry

8. Reverse Asset Allocation: Alternatives At The Core by P. Brett Hammond, TIAA-CREF Asset Management (2007)
Institutional investors have shown an increasing interest in alternative asset classes—including private equity, venture capital, real estate, commodities, hedge funds, and others—due to their strong performance and low correlations with traditional assets. In addition, diminished expectations for returns from traditional assets have made alternative assets even more attractive. The inclusion of alternatives in formal asset allocation models, however, can make these models highly sensitive to small changes in a portfolio’s allocations. Moreover, because most alternatives do not have long track records, some institutions may be unsure how to predict the risk/return behavior of these investments in a traditional asset allocation model.

A new approach—“reverse asset allocation”—addresses these challenges by taking into account the special characteristics of alternative assets. Unlike traditional asset allocation, which, to produce the bulk of overall return, puts equities at the core of the portfolio and then, to limit risk and improve efficiency, adds bonds plus alternatives, reverse asset allocation does the opposite. It begins by finding the expected return from a desired allocation to a core group of alternative assets, and then adds bonds and equities as the completion elements, to achieve the overall desired portfolio characteristics. the rationale for reversing the usual approach is based on the notion that alternatives offer an opportunity to obtain asset-based return alpha with low correlation to traditional asset classes while limiting risk.
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Post by oneleaf »

The Cordon Bleu School of Portfolio Design by Paula H. Hogan, CFP, CFA
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Post by gbs »

The Ultimate Buy-and-Hold Strategy
by: Paul Merriman

contributed by: CyberBob
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Subsequent studies to the BHB Study

Post by Barry Barnitz »

Ever since the publication in 1986 of the oft quoted Brinson, Hood, and Beebower (BHB) study on asset allocation, debate has swirled about the validity of the study's conclusions. A sampling of available studies on the BHB controversy are rendered below:

1. Does Asset Allocation Policy Explain 40%, 90%, or 100% of Performance? by Roger G. Ibbotson and Paul D. Kaplan
Disagreement over the importance of asset allocation policy stems from asking different questions. We used balanced mutual fund and pension fund data to answer the three relevant questions. We found that about 90 percent of the variability in returns of a typical fund across time is explained by policy, about 40 percent of the variation among funds is explained by policy, and on average about 100 percent of the return level is explained by the policy return level.
2. The Contribution of Asset Allocation Policy to Portfolio Performance by Wolfgang Drobetz and Friederike K.R.
It is well known that asset allocation policy is the major determinant of fund performance. However, there is substantial disagreement about the exact magnitude of the contribution of asset allocation. Following the approach in Ibbotson and Kaplan (2000), we use German and Swiss balanced mutual fund data to show that the correct answer depends on the specific question being asked. We find that more than 80 percent of the variability in returns of a typical fund over time is explained by asset allocation policy, roughly 60 percent of the variation among funds is explained by policy, and more than 130 percent of the return level is explained, on average, by the policy return level.
3. The Asset Allocation Debate: Provocative questions, enduring realities by Vanguard Institutional Research
Ever since the 1986 ?Brinson study? stated that asset allocation accounts for more than 90% of the variation in portfolio returns over time, investment professionals have been debating its implications. The opposing view, introduced by William Jahnke in 1997, counters that asset allocation alone cannot account for the variation in returns across portfolios. This report analyzes industry research surrounding this ongoing debate (including recent Vanguard studies), with an in-depth review of static versus dynamic asset allocation strategies and index versus active portfolio construction.
4. Another Look at the Determinants of Portfolio Performance: Return Attribution for the Individual Investor by French, Craig W.
This study examines the total return of investment portfolios composed of mutual funds and analyzes the contributions of strategic asset allocation (investment policy), tactical timing (the periodic over- or underweighting of asset classes relative to the strategic weightings), and security selection (the selection of individual mutual funds to represent asset classes). The results of Brinson, Hood and Beebower (1986) and Brinson, Singer and Beebower (1991) are confirmed using a sample free of several data limitations in their samples.
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The 4-Fund Portfolio

Post by CyberBob »

I didn't notice Taylor Larimore's 4-Fund Portfolio specifically mentioned anywhere on this site.
It is a pinnacle of portfolio sophistication and simplicity.


A Money-Market Fund
Total Stock Market Fund
Total International Fund
Total Bond Market Fund


Fill-up your taxable account in the order shown. Put what's left into your tax-deferred account(s).


Maximum Diversification (low risk)
Zero overlap
No manager changes
No style drift (from benchmark index)
Desired stock/bond/cash allocation is easy.
Never a need to rebalance within asset classes
High probablity of beating most funds
Never below index performance
Minimum maintenance
Lowest possible cost
Low taxes


1. High-income investors should substitute a tax-exempt bond fund for Total Bond Market Index Fund and use a Tax-Exempt Money Market Fund.

2. Larger portfolios may benefit from adding TIPS, REIT, or Small-Cap Value in tax-deferred accounts.

These two links explain the sophisticated logic of the 4-fund portfolio (recommended by Mr. Bogle):

1. The Arithmetic of Active Management by Nobel Laureate William Sharpe

2. Investing in Total Markets by John Norstad, et al.

Best wishes.
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Post by bob90245 »

The Rewards of Multiple-Asset-Class Investing by Roger C. Gibson, CFA, CFP®
Editor's note: This month, in honor of the Journal of Financial Planning's 25th anniversary, we are reprinting "The Rewards of Multiple-Asset-Class Investing," by Roger C. Gibson, CFA, CFP®, originally published in March 1999. This persuasive and prescient article made the case, exactly one year before the stock market began its dramatic plunge in 2000, for the value of diversifying among asset classes as a way to reduce volatility and increase overall returns.
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Asset Class Correlations

Post by Barry Barnitz »

1. The Volatility of Correlation: Important Implications for the Asset Allocation Decision by William J. Coaker II, senior investment officer of equities for the San Francisco City- County Employees Retirement System. (2006)
* The severity of how much correlation changes, even over longer periods of time, has not been adequately understood.

* This paper analyzes the changing correlation of 15 asset classes measured against the S&P 500 over a 35-year period, and the impact of those changes on asset allocation decisions. It measures the correlations in rolling one-, three-, five-, and ten-year time series, from 1970 to 2004.

* The article also evaluates whether 15 asset classes have helped or hurt in years the S&P 500 has declined, and whether growth or value styles are more correlated to the index.

* The average variance in correlation measured 0.98 over one year and 0.25 over ten years. In short, the relationship among many of the asset classes appears to be inherently unstable.

* Large value provides more diversification benefits than large growth, and small value provides more diversification than small blend or small growth. Emerging markets may provide higher returns and greater diversification than developed nations. But the low correlations of small value and real estate may not hold up during the next broad market decline.

* Correlations exhibit uniqueness, meaning periods are distinct from previous time periods. For example, international stocks' correlation to the S&P 500 was 0.48 from 1970 to 1997, but 0.83 from 1998 to 2002.

* Rather than rely on historical correlations, a more comprehensive and dynamic approach is needed in making asset allocation decisions.
2. Emphasizing Low-Correlated Assets: The Volatility of Correlation by William J. Coaker II, senior investment officer of equities for the San Francisco City- County Employees Retirement System (2007)
• The fact that correlations change is well known. But the severity of change, and which relationships are subject to change, needs to be better understood because it has important implications for containing risk.

• This study evaluates the volatility of correlation among 18 asset classes to each other to determine the consistency or inconsistency of relationships. It provides not only the long-term correlations of the assets, but the standard deviation of correlation and the range of correlations based on two standard deviations from the average correlation. It also summarizes the correlations in a probability distribution.

• In the asset allocation process, some assets often are used together even though diversification benefits have been very low. For example, the correlations of the S&P 500 to large growth, mid-blend to mid-growth, small blend to small growth, and large value to mid-value, have been very strong.

• Several assets often are neglected in the asset allocation decision, even
though their diversification benefits have been very high. Natural resources, global bonds, and long-short, for example, stand out as having consistently low correlations to all the other assets in this study.

• Growth and blend styles are highly correlated, and using them together does little to reduce risk.

• Real estate, high-yield bonds, U.S. bonds, and long-short are more closely linked to value investing than growth. Emerging markets are somewhat more connected to growth than value.

• The asset allocation decision should emphasize low-correlated assets that satisfy return objectives.Two sample portfolios for different style investors show how risk and return are improved by combining lower-correlated assets.
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Post by AzRunner »

I read the article mentioned in the first post by John Y. Campbell on Strategic Asset Allocation: Portfolio Choice for Long-Term Investors, which is a good introduction to the book, Strategic Asset Allocation, by Campbell and Viceira.

I presently have this book, via Interlibrary loan from the U of Arizona. Each chapter has an introduction, then math, charts and graphs followed by a wrap-up. My plan is to go through the introductions and conclusions and then work through some of the math, to the extent I have time before June 12th due date.

So far, the main thing to be reinforced is the primacy of TIPS for the conservative long-term investor.

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Re: Asset Allocation

Post by Mr_Efficiency »

gbs wrote:[contributions needed]

Planetary wealth can be categorized by Asset Class

- Stocks (approx 50% U.S., 30% Europe, 20% Rest)

- Bonds (approx 40% U.S., 30% Europe, 20% Japan, 10% Rest)

- Cash In Account (Money Market, CDs, Checking, Savings)

- Cash In Hand (Dollars, Euros, Pounds, Yen, Yuan, Rupis)

- Potential Cash (casino bets in progress, derivatives, insurance policies, etc.)

- Perpetual Tangibles (Paintings, Gold, Antiques)

- Real Estate (Land and its fixed improvements)

- Potential Tangibles (Mines, Drillsites, Non-Food Farms, Wind, Sunlight)

- Consumable Tangibles (Inventories of Oil, Steel, Food, Water)

...can anyone think of others?
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Post by Adrian Nenu »

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Post by CaliJim »

Dynamic Asset Allocation is also an option:

AF Perold, WF Sharpe, "Dynamic strategies for asset allocation" Financial Analysts Journal, 1995.

Link: ... Sharpe.pdf

Three Asset Allocation schemes are discussed:

Constant Proportion = Dollars in stocks = m * (Assets - Floor)

Constant Mix Asset Allocation (ie: 60/40 rebalanced annually or when bands are reached) is a special case of Constant Proportion where Floor=0 and 0<m<1

Buy and Hold Asset Allocation (ie: start at 60/40 and never rebalance) is a special case of Constant Proportion, where Floor = Bond$, and M=1.
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Re: Asset Allocation

Post by jennyb »

thanks..i think Bill Schultheis has some great advice. I truly respect him.