From the April 2009 issue of Wealth Manager Web • Subscribe!

Finding the Right Balance

The global financial crisis of 2008 seemed to leave investors with nowhere to hide. Large cap, small cap and international stocks all declined. Emerging markets plummeted, and commodities spiraled downward from dizzying heights. Investors who shun risky assets may have avoided these large losses, but risk aversion generally results in subpar returns over time. Risky portfolios managed by exceptional market timers might have performed well, but few people possess market-timing skills.

Investors need another approach, one that combines exposure to risky assets with the ability to mitigate risk and avoid the kind of catastrophic losses many investors suffered last year. Portfolio diversification, by combining low-volatility fixed income with higher-risk/higher-return asset classes, provides superior risk-adjusted returns across market cycles.

Asset allocation in a diversified portfolio

Savvy market timers would choose to hold 100% of their portfolios in equities during bull markets and 100% in fixed income during stock market declines. However, since very few investors possess market-timing skills, they need to settle on an asset allocation strategy that provides them with the highest possible returns over time, given their stated risk preference. Ultimately, the asset allocation decision is responsible for 90% of a portfolio's long-term performance, according to Richard A. Ferri in his 2005 book, All About Asset Allocation.

In 2008, the power of asset allocation shone. While a portfolio invested entirely in stocks (as measured by the S&P 500) would have declined by 37%, a diversified stock/bond portfolio would have fallen by a more manageable--though still painful--20%. This diversified portfolio--60% S&P 500/40% Merrill Lynch Domestic Master Bond Index--would also have performed favorably over a longer timeframe. Since 1989, a 60/40 mix would have provided more than 95% of the aggregate returns of an all-stock portfolio, with less than two-thirds of the volatility. For many investors, this reduced risk far outweighs the cost of sacrificing a small portion of their potential gains.

Tactical allocation shifts

Fixed income has performed extremely well since the early 1980s, in part because of a secular bull market that has seen interest rates fall from the mid-teens to less than 3%. Equity markets, on the other hand, have just experienced a sharp decline, which follows on the heels of the bear market brought on by the bursting of the tech bubble. As a result, the stock market has been essentially unchanged for the past 12 years, while fixed income has looked very good by comparison. Investors troubled by the stock market stagnation should remember that equities have historically followed these cycles with equally long periods of above-average returns.

Financial theory also tells us that over long periods of time riskier asset classes should post higher returns than safer asset classes. If we assume this relationship will hold true in the future, then it might be logical to increase a portfolio's equity allocation, though only marginally. Asset allocation changes should generally be tactical, not strategic, and a diversified portfolio should almost always include both equities and fixed income.

Allocation within fixed income

Investors' goals and risk tolerance will determine how their fixed-income assets are allocated. However, they should keep in mind the role of fixed income: to provide consistent performance in order to moderate the overall portfolio's volatility.

This approach argues for maintaining a relatively conservative risk profile within an investor's fixed-income holdings. The majority of the portfolio should consist of Treasury, agency, mortgage-backed and high-grade corporate securities. Excluded from this list are high-yield bonds, emerging market bonds and complex securitized products--sectors not known for their safety and stability. Moreover, many investment professionals classify high yield as a separate asset class--neither equity nor fixed income. Therefore, while high yield might be included as part of a diversified portfolio, it would not be considered part of the fixed-income allocation.

Segmenting a fixed-income portfolio

Many investors choose to distribute their fixed-income holdings between a longer-term "core" portfolio and a short-term "liquidity" portfolio. This approach, often referred to as "segmentation," both ensures adequate liquidity for meeting expected or unexpected cash flow needs and retains the opportunity to generate higher returns over time.

A core portfolio should hold high-credit-quality securities and have a moderate average maturity. Many core portfolios track one of the popular fixed-income benchmark indices that measure the performance of a wide range of investment-grade securities with an average maturity of four or five years.

Investors concerned about interest-rate risk might structure similarly high-quality portfolios with a slightly shorter average maturity. These portfolios will often contain a range of securities with an average maturity of two to two-and-a-half years. Over time, these shorter portfolios provide about 88% of the returns of the longer-term portfolios with only 50% of the interest-rate risk (comparing 10-year performance of Merrill Lynch Domestic Master Index and Merrill Lynch 1-5 Year Government/ Corp A or better Index).

Many investors will also choose to include a short-term liquidity portfolio as part of their fixed-income holdings. The liquidity portfolio frequently has an average maturity of less than one year, and therefore very low interest-rate risk. It also holds very high-quality securities, thereby minimizing both credit and interest-rate risks.

The liquidity portfolio is an ideal tool for capital preservation that can be used to meet expected or unexpected cash flow needs. As market opportunities present themselves, the liquidity portfolio can also provide funds for reallocation to other asset classes. Appropriate holdings for a liquidity portfolio might include T-bills, agency discount notes, certificates of deposit or commercial paper.

Fixed-income investors must often choose between pooled products or individual securities. Pooled products are easy to use, but sometimes suffer from a lack of transparency, and investors do not directly own the underlying securities. These drawbacks were highlighted during the market turmoil following Lehman Brothers' collapse. On the other hand, direct ownership of fixed-income securities can require more effort and a larger portfolio in order to be efficient--but this approach is also fully transparent and directly controlled by the investor.


On the surface, portfolios with a high allocation to fixed income may appear attractive, especially given recent market events and investor sentiment. However, a contrarian approach argues that equities may offer above-average long-term value right now. In balancing investors' heightened desire for safety with the necessity of achieving reasonable returns, a moderate approach is advisable. This might entail a tactical decision to shift allocations slightly in favor of equities. However, most diversified investors will continue to maintain a reasonably well-balanced portfolio that includes fixed-income securities.

For many investors, the fixed-income portion of their portfolio will provide safety, stability, liquidity and consistent returns. Investors might also benefit from segmenting their fixed-income holdings between a core portfolio designed to achieve higher returns and a liquidity portfolio to preserve capital and meet cash flow needs. By incorporating these concepts into their asset allocation strategy, investors can enhance their ability to achieve superior risk-adjusted returns across market cycles.

Brian Perry ( is a vice president and investment strategist at Chandler Asset Management in San Diego.

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