Guide to asset allocation

Review your objectives and financial situation to generate current incomes and keep your capital. The asset allocation model should tend to bonds and money market valuables. If you are in no need of current incomes and the investor is investing capital and future growth, the weigh should incline more towards stock and real assets.

Determine your risk tolerance. If you have a long term horizon and you can accept the risk of the stocks and real estate markets a larger amount can be invested in these. If you cannot tolerate the risk, the allocation must be oriented to bonds and money market valuables.

Consider your time frame. If you are young and have a long term horizon (round 25 years) allocate a greater percentage in stocks. If you possess shorter time frame the assignment of resources should be oriented towards bonds with a minimum percentage going to stocks.

Your expectations over your investments should be more realistic. Returns from the last two decades have been outstanding. Long term bonds in the 80s had an average return of about 13% annually. Stock returns were highly exaggerated during the late 90s due to the technological boom and internet. But on 2000 prices lowered to more realistic levels.
The S&P 500 Index, for instance, earned an 37% average in 1995, 22% average in 1996, and 33% average in 1997. The last two decades have been extraordinarily outstanding for the bonds and stocks market. The reason is that there was an interest rate turndown of about 17% in 1980 in relation to early 2000?s 3% - 5% interest rate.
In the future you should lower your return expectations to more realistic levels and numbers.

Consider the risk-return change in the asset allocation model. In how you assign your assets will depend how risks will affect your return.
According to Ibbotson and Sinquefield (1994) diversification within the different kinds of assets investments reduces risk levels and better returns. The 3 portfolios being studied used information during 1927 –1993. The first portfolio merely consisted in long term government bonds, and had an average annual return of 5.5% with an 11.3% risk (normal deviation). In the second, we count with a more diversified portfolio, 63% is formed by Treasury bonds, 12% long term government bonds and 25% in large companies common stocks. This portfolio had the same return as the first one, 5.5%, but the risk dropped to 6.1%. The third portfolio consisted of 52% of large companies stocks, 14% in long term government bonds, and 34% in Treasury bonds. This portfolio an 8% annual return along with an 11.3% risk. It is the same risk the first portfolio had, but with larger return.

After determining the asset allocation model the next step will be to determine the individual investment. In a speech delivered at the American Association of Individual Investors National Meeting in July 1998, John J. Brennan used a portfolio with 100% invested in foreign stocks for a 5 year period that ended in 1990 as an example. This portfolio based on Morgan Stanley EAFE Index, could have had a better performance than a stock portfolio based on S&P 500 Index. On the other hand, during this same 5 year period a portfolio consisting in 100% stocks based on the S&P 500 Index would have had a better performance than that of foreign stocks. In order to reduce total risk you should divide your stock allocations into different sections of the economy and from there choose individual stocks for each section. The same should be done with your bond portfolio.

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