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Author: rkmacdonald Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 75539  
Subject: Re: Important IRA Allocation Question Date: 12/17/2004 6:44 PM
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Hozghewon wrote:
I've heard from financial planners that more imporantly than the funds you pick to invest in for your retirement accounts, 90% of the success will be based on your allocation of those investments. Now, my question is how do I find the most optimal allocation possible? I have never seen any researches on the different allocations that various firms recommends, and I also wonder what the average annual returns are based on the types of allocations that are being recommended.

Finding the optimum allocation amoungst a variety of funds is not a trivial matter. Professional money managers do this analysis with software called an MVO (Mean Variance Optimizer). This software allows the money manager to enter the client's desired risk, and it will analyze the best allocation for each of the assets in the chosen asset list.

However, this doesn't really work well, because MVO's only tell you what the best allocation would have been in the past. They don't tell you about the future, and one of the most important thing to know about investing is that past results do not always indicate future performance. In addition, the average individual investor doesn't have access to MVOs (or more specifically, the data that is needed to run them), so there really isn't any scientific way for you to optimize your allocations.

I've always known that the stock market in the long run averages 10% annual return, which means that if 100% of the investment is allocated in the stock market, into index funds or what not, 10% would be the out come. However, no one would recommend even the most aggressive investor to allocate 100% of their savings in the stock market even if they still have 37 years to go before they'll touch the money.

In a case where you only allocate 65% of the money into stocks, or even 80%, will your total portfolio still generate 10-12% return per year since they're not all in the stock market?


If you had put all your money in the S&P 500 over the last 100 years, you would have enjoyed a total return of about 11%. If you had split your investments at 60% equities and 40% short term bonds, your total return would have been about 9%.

However, if you are looking only at potential gains, then you are missing half the picture. You have to look at risk as well as gains. You can go back through history and find long periods where the gains of the S&P 500 were far less than 11%. Look at the period following 1929. Even with dividends reinvested, it would have taken you over 10 years to get back where you were.

For a more recent example that hasn't finished playing out yet, how long will it be until the S&P 500 gets back to where it was in the spring of 2000? It's been nearly five years so far, and it has still not fully recovered.

The 11% return of the S&P 500 is a result of recent long periods of dramatic gains, like the 1990s. Most economists say that the average return of the equity market is probably going to be in the 6% range over the next 12 years or so. Of course, predictions like that are usually wrong about one second after they are made, but they do give you something to think about. Do you want to gamble your future on the market achieving its historical 11% gain over the next 30 years? What if it makes only 6% over that period?

This is why bonds (or bond funds) are so important. They provide a level of protection from long periods of underperformance in the equity market. They don't stop you from losing during those times, they just reduce your losses. This becomes more and more important the closer you get to retirement, because you have less and less time to recover from a major stock market crash like the one in 2000. What if you were 100% in equities in 2000 and planning to retire in 2001? You be in a world of hurt!

So, by far, the most important asset allocation decision is the equity/bond split. You should investigate your tolerance to risk; ie, how would you feel if your retirement portfolio lost half it's value, or 30%, or 20%. How much loss can you stand? Adding bonds can reduce the chance of losses to a chosen level. Once you make that decision, further diversification is possible, but it will give you a much smaller positive effect compared with the initial equity/bond split decision.

I recommend that you read William Bernstein's book 'The Intelligent Asset Allocator' or, if you are mathematically challenged, his more recent and easier book, 'The Four Pillars of Investing' to get a foundation of asset allocation knowledge to work from.

Russ
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