Asset Allocation: Your Critical Investment Decision

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1 Asset Allocation: Your Critical Investment Decision Despite what you might read in the financial media, choosing the best-performing investments is not the key to achieving your long-term success. Unfortunately, too many investors rely on such shortcuts as star ratings or past performance rankings when developing their plans for investing, only to find themselves disappointed in their choice and chasing the next best-performing investment. The most important investment decision you can make is to define clearly, in writing, your investor profile and work with a trusted advisor to match that profile to an appropriate portfolio of investments diversified across a mix of asset classes. The allocation of your investments among various asset classes is the first step to achieving your long-term objectives. By adopting an asset allocation model that matches your unique investor profile, you create a blueprint for your future investment decisions, guided by an objective criteria that can counter emotional factors like fear and greed. What is asset allocation? Asset allocation is a strategy for investing that is designed to reduce volatility, or the variability of returns, by diversifying across a variety of investments, such as stocks, bonds, real estate, and alternative investments like commodities. Asset allocation is effective when the asset classes are unlikely to generate parallel returns at the same time. Stock Selection 4.6% Other 2.0% Market Timing 1.8% Why is asset allocation so important? In 1991, a landmark study of pension plans, by Brinson, Singer & Beebower, reached a monumental conclusion that asset allocation, not security selection or market timing, was the primary determinant of the variation in portfolio returns. This study reinforces the assertion that the asset allocation decision is far more meaningful to long-term success than either the selection of individual securities, or the timing of buys and sells. How does asset allocation work? The effect of asset allocation on the volatility of portfolios can be graphically represented. Let s look at the performance of two hypothetical accounts, as illustrated in the graph on the right, over a one-year period. In our first account, let s imagine that we engage in a typical asset allocation decision and invest $20,000 divided equally between a volatile investment (red line) that goes up and down, say up 12 percent one month and down 8 percent the next, and then combine it with a steadier investment (blue line) that goes up and down half as much (up 6 percent one month and down 4 percent the next). In this example, when our volatile investment goes up, our steadier investment also goes up, but only half as much. Conversely, when our $24,000 $23,000 $22,000 $21,000 $20,000 $19,000 Source: Brinson, Singer & Beebower Return on Investment A (Volatile Investment) Return on Investment B (Steadier Investment) Combined Portfolio Value Asset Allocation Decisions 91.5 % $18,000 - Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec This graph represents the one year performance of an account comprised of two hypothetical investments with positive correlation. This chart is shown for illustrative purposes only and is not intended to predict or depict the returns of any particular investment. Past performance does not guarantee future results. 1 0% - 1

2 volatile investment goes down, our steadier investment goes down only half as much. From the chart we can see the green wavy line grows about 15 percent to a little over $23,000 not bad, but a pretty bumpy ride. Investors often use a shortcut and focus only on the 15 percent return number and pay little heed to the accompanying volatility that comes with a potential 15 percent return. At the bottom of a wave investors often recognize a losing position, get scared and sell out of the investment. In our second hypothetical portfolio, let s look at the impact of a vital component of asset allocation, a statistical event called correlation. Correlation simply measures the rate at which the movement of one variable is related to the movement of another. In our case above, every time our risky asset went up, our not-so-risky asset went up, and every time our risky asset went down our not-so-risky asset did the same. This is called positive correlation. What would our second account look like if our two assets had negative correlation, meaning that every time our risky asset went up, our not-so-risky asset went down, and every time our risky asset went down, our not so risky asset went up? As you can see from the chart to the right, we still end up with our same 15 percent return and an account value of a little over $23,000. However, since our investments had negative correlation, the green line is smoothed out quite a bit. The principle of correlation is extremely important in creating a well-diversified portfolio. A basket of investments that perform similarly do not provide as much benefit as diversification across investments that perform differently. $24,000 $23,000 $22,000 $21,000 $20,000 Return on Investment A (Volatile Investment) Return on Investment B (Steadier Investment) Combined Portfolio Value 1 0% In reality, assets don t have the type of perfect correlations represented in our graphs, but the degree to which assets are positively or negatively correlated is an important component in applying asset allocation principles to a portfolio. $19,000 $18,000 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec This graph represents the one year performance of an account comprised of two hypothetical investments with negative correlation. This chart is shown for illustrative purposes only and is not intended to predict or depict the returns of any particular investment. Past performance does not guarantee future results. - - The Impact of Asset Allocation on Investor Behavior One of the biggest challenges you may face in achieving your long-term objectives is your own emotions and how you react to the uncertainties you face. Look back to the first chart of our positively correlated securities. How would you react when your portfolio was on one of the downward sloping lines? Would you react differently to one of the downward sloping lines on the second chart? Many investors, reacting to emotions, feel compelled to make changes to a volatile portfolio like our first one, and are more comfortable reacting to emotions with a less volatile portfolio like the second. If smoother returns help you stay the course and stick with your investment program, and both accounts end up in the same place, there is a tangible benefit to choosing a portfolio that reduces volatility. When you accept the benefit of diversification, you must avoid the tendency to focus on the performance of only a part of your portfolio. Diversification allows you to combine risky assets with non-risky assets in a manner that reduces overall risk. What diversification does not do is make a risky asset a non-risky asset. In fact, because we seek low correlation amongst assets, if no single component of a portfolio is underperforming relative to other components of the same portfolio, chances are that the 2

3 portfolio is not properly diversified. All too often, investors accept the principle of asset allocation only to focus on the isolated performance of certain, more volatile asset classes that are included to reduce overall volatility. This microscopic approach to portfolio analysis, called asset segregation, causes investors to abandon their overall asset allocation plan in favor of choosing only hot (i.e. positively performing) investments. 1st Global s commitment to multi-asset class diversification helps you focus on the performance and composition of your portfolio as a whole. The Positive Impact of Asset Allocation To put in perspective the positive impact of asset allocation on our decision-making, let s first look at the performance of select basic asset allocations, specifically Fixed Income and U.S. Large Cap Equities. On the graph to the right, we map our hypothetical portfolios, with their return compared to their volatility, or risk. By combining two asset classes, Fixed Income and U.S. Large Cap equities, we can create a range of portfolio mixes that match an investor s specific risk tolerance to a desired return. In our next chart, we show the impact of adding a 5 percent allocation of a highly volatile asset class, in this case commodities, to the basic asset allocations described above. The chart demonstrates the significant impact of an additional layer of diversification. On the chart, the new line (green) does not move up the chart (return stays the same), but it does move to the left (volatility goes down). By adding a volatile asset class with low correlation to our existing conservative asset classes, we can continue to meet our return objectives, with lower volatility. Portfolio Return 13% 12% 11% 9% Data from 12/ /2006 Large Cap & Fixed Income 100% Fixed Income Fixed Income / 90% Large Cap 20% Fixed Income / 80% Large Cap 30% Fixed Income / 70% Large Cap 40% Fixed Income / 60% Large Cap 50% Fixed Income / 50% Large Cap 60% Fixed Income / 40% Large Cap 70% Fixed Income / 30% Large Cap 80% Fixed Income / 20% Large Cap 90% Fixed Income / Large Cap 8% 6% 7% 8% 9% 11% 12% 13% 14% 1 Standard Deviation (Volatility) 100% Large Cap This graph represents the return and volatility (standard deviation) of a combination of two asset classes, U.S. Large Cap Equity and Fixed Income as represented by the S&P 500 and Lehman Brothers Government/Credit Bond Index. This chart is shown for illustrative purposes only and is not intended to predict or depict the returns of any particular investment. Past performance does not guarantee future results. Data from 12/ /2006 Portfolio Return 13% 12% 11% 9% Large Cap & Fixed Income Large Cap, Fixed Income & Allocation to Commodities 8% 6% 7% 8% 9% 11% 12% 13% 14% 1 Standard Deviation (Volatility) This graph represents the return and volatility (standard deviation) of two combinations, a mix of two asset classes, U.S. Large Cap Equity and Fixed Income, and three asset classes, U.S Large Cap Equity, Fixed Income and Commodities as represented by the S&P 500, Lehman Brothers Government/Credit Bond Index and the Goldman Sachs Commodity Index. This chart is shown for illustrative purposes only and is not intended to predict or depict the returns of any particular investment. Past performance does not guarantee future results. 3

4 Security Selection: Key Criteria Investors often define the best funds or stocks as the ones with the best performance over a select time period. However, according to the study by Brinson, Singer & Beebower, nearly 92 percent of the variability of returns is accounted for by how assets are allocated not by which securities are selected. Does this mean that the selection of mutual funds, stocks or bonds is meaningless, or rather accounts for only 5 percent of returns? Not necessarily. Since the overriding contributor to portfolio returns is the allocation of assets among various asset classes, the most important characteristic in selecting a security is its ability to closely represent its underlying asset class. 1st Global s Investment Philosophy The principles of multi-asset class diversification, and the benefits of asset allocation, are the foundation for 1st Global s investment philosophy. Our asset allocation strategies utilize six core asset classes: U.S. Small Cap Equity, U.S. Large Cap Equity, International Equity, Fixed Income, Real Estate, and Alternative Investments/Commodities. The embodiment of the 1st Global philosophy of diversification through disciplined asset allocation are the five model portfolios composed of various blends of six asset classes 1. 20% % % 20% 1 20% 30% U.S. Large Cap Equity Real Estate U.S. Small Cap Equity International Equity Alternative Investments Fixed Income Each model portfolio exhibits a different expected rate of result along with a commensurate level of volatility (risk). With the help of a trusted CPA wealth management advisor, you can define your own investor profile (risk and time horizon) and choose a model that meets your requirements for both returns and volatility. 1 Source: 1st Global s Investment Philosophy White Paper, Diversification Through Multi-Asset Class Investing: The 1st Global Philosophy, describes the process behind the construction of these portfolios and is available from your 1st Global Financial Advisor. 4

5 1st Global s asset allocation models are not only designed to provide, or attempt to provide, lower volatility risk than many of our previous hypothetical models, but offer the potential for greater returns as well. When selecting individual investments, investors are compensated for accepting a greater risk of loss by larger potential returns. For this reason, risk and return are generally positively correlated: the greater the risk, the greater the reward. Since we know that diversification can reduce overall portfolio risk, we can add riskier assets that carry a greater potential for higher returns. While in isolation individual investments or asset classes may bear risk higher than our comfort level, but by combining these assets with others having different correlations, we can reduce risk, yet still have the potential for higher returns from the riskier assets. By diversifying across six distinct asset classes with varying correlations, we are able to move the red line in the graph up and to the left of our green and blue lines, showing we have added return and reduced risk. 1 14% 13% 12% 11% 9% Conservative Ultra-Conservative Large Cap & Fixed Income Large Cap, Fixed Income & Allocation to Commodities 1st Global Model Portfolios Aggressive Growth Moderate Data from 12/ /2006 Growth 8% 6% 7% 8% 9% 11% 12% 13% 14% 1 Standard Deviation (Volatility) This graph represents the return and volatility (standard deviation) of three combinations, a mix of two asset classes, U.S. Large Cap Equity and Fixed Income, three asset classes, U.S. Large Cap Equity, Fixed Income and Commodities, and the 1st Global Advisors, Inc. asset allocation models as represented by the Lehman Brothers Government/Credit Bond Index, S&P 500 Index, Ibbotson Small Company Index, MSCI EAFE Index, Goldman Sachs Commodity Index, NAREIT Equity Index and U.S. 30 day Treasury Bill Index. This chart is shown for illustrative purposes only and is not intended to predict or depict the returns of any particular investment. Past performance does not guarantee future results. For more information on 1st Global Advisors models please refer to 1st Global s Investment Philosophy White Paper, Diversification Through Multi-Asset Class Investing: The 1st Global Philosophy, describes the process behind the construction of these portfolios and is available from your 1st Global Financial Advisor. Conclusion In a world where investors are bombarded by new information offering the best funds or the most recent hot investment strategy, multi-asset class asset allocation almost seems simple and boring. In 1990, however, this widely accepted approach to rational and consistent investing won Harry M. Markowitz a share of the Nobel Prize in Economic Sciences. In the 55 years since Mr. Markowitz wrote his first paper on the subject of balancing risk and return, the implications of this original study continue to be applicable in asset management. Asset allocation, and not picking the hot or best investment product, is the key to achieving long-term goals. Security selection is important, but only in working to ensure that your specific investments are representative of underlying asset classes. As an investor, you may achieve your long-term goals by adhering to your asset allocation strategy, understanding that your portfolio will have volatility over short-term periods, and understanding that for diversification to work, components of your portfolio will underperform or outperform at various times relative to other components of the same portfolio, while others perform in a balancing manner. Delivering multi-asset class diversification through model portfolios offers a framework within which you and your financial advisor can make rational investment decisions without fear or greed, and offer a baseline against which you can review progress towards long-term investment goals. The most important part of achieving your long-term goals and objectives is the counsel of a trusted advisor. While 1st Global s investment philosophy and asset allocation models are designed to produce long-term returns, these are enhanced by the relationship with your financial advisor. Your financial advisor is the key to reminding you of your long-term goals, reinforcing the importance of asset allocation, and customizing systematic, automated rebalancing strategies. 5

6 Source of index data: PSN Informa The Lehman Brothers Government/Credit Bond Index includes a combination of the Lehman Brothers Government Bond Index which tracks returns of U.S. treasuries, agency bonds and 1-3 year U.S. Government obligations, and the Lehman Brothers Credit Index which tracks returns of all publicly-issued fixed rate, nonconvertible, dollar denominated, SEC registered investment grade corporate debt. The Goldman Sachs Commodity Index is a composite index of commodity sector returns representing an unleveraged longonly investment in commodity futures that is broadly diversified across the spectrum of commodities. The S&P 500 is a market capitalization-weighted index of 500 widely-held stocks often used as a proxy for the stock market. The Ibbotson Small Company Index is made up of the smallest 20 percent of publicly-traded stocks. The MSCI EAFE is a market-capitalization weighted index of 21 non-u.s., industrialized country indexes. The NAREIT Index includes all REITs currently trading on the NYSE, NASDAQ, and ASE. The indexes used in this illustration are unmanaged indexes of common stocks, bonds, or other securities. An investment cannot be made directly in an index. Standard deviation is a statistical measure of the historical volatility of a portfolio. Higher standard deviation numbers indicate higher volatility and hence, higher risk of principal loss. Diversification of your overall investment portfolio does not assure a profit or protect against a loss in declining markets. International/Global Investing: International investing presents certain risks not associated with investing solely in the United States. These include, for instance, risks relating to fluctuations in the value of the U.S. dollar relative to the values of other currencies, custody arrangements made for foreign holdings, political risks, differences in accounting procedures and the lesser degree of public information required to be provided by non-u.s. companies. Emerging Markets: Investing in emerging markets involves greater risk than investing in more established markets. Such risks include exchange rate changes, political and economic upheaval, the relative lack of information about these companies, relatively low market liquidity, and the potential lack of strict financial and accounting controls and standards. Higher-yielding/Lower-rated corporate bonds: These bonds, more commonly known as junk bonds, have a greater risk of price fluctuation and loss of principal and income that U.S. government securities such as U.S. treasury bonds and bills, which offer a government guarantee of repayment of principal and interest if held to maturity. Sector Funds: Investing in a non-diversified fund that concentrates holdings into fewer securities or industries may involve greater risk than investing in a more diversified fund. Micro Cap, Small Cap and Mid Cap Funds: Investing in micro, small or mid-sized companies may involve risks not associated with investing in more established companies. Since equity securities of smaller companies may not be traded as often as equity securities of larger, more established companies, it may be difficult or impossible for the fund to sell. The returns of the actual investments selected as part of your portfolio will vary. Before investing in any mutual fund, investors should carefully consider a fund s investment objectives, risks, charges and expenses. Fund prospectuses contain this and other information about the funds, and may be obtained from your financial advisor. 6