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Asset allocation is the process of diversifying investments among various asset classes, such as stocks, bonds, international securities and cash. The strategy seeks to maximize returns for a given level of risk and specific portfolio objectives.
· Stocks have been the best performing investment class over the long term, but with higher volatility.
· Bonds provide investment income and diversification, while generally reducing portfolio volatility.
· International stocks offer the potential for higher returns with a low correlation with U.S. stocks.
· Cash provides liquidity as well as available funds to take advantage of market opportunities.
Importantly, asset classes perform differently depending on the economic environment, such as expansion, recession, or rising inflation. Diversification among the various asset classes works to dampen, or mute, volatility because not all asset classes rise or decline equally during changing economic conditions. In fact, some asset classes may remain stable or even increase in value when others decline. A portfolio with low correlation among each asset class can provide more consistent returns over time.
Portfolio performance for a given level of risk can be optimized through the use and application of the Efficient Frontier. The Efficient Frontier is a theoretical representation of an ideal mix of stocks, bonds, international securities, and cash, with different expected return characteristics for any given level of risk. Developed by Nobel Prize winning economist Harry Markowitz, PhD of the University of Chicago, the goal is to maximize portfolio returns through the application of his techniques. Included in this analysis are investment objectives, time horizons, and attitudes toward risk. There is no consideration for income nor capital gains taxes.
Neither asset allocation nor diversification can ensure a profit or prevention of loss in times of declining values. International investing entails special risk considerations, including currency fluctuations, lower liquidity, economic and political risks, and differences in accounting methods. Past performance cannot guarantee future results. In general the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Fixed income securities also carry inflation risk and credit and default risks. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.