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Lesson
1: What is Asset Allocation Asset
Allocation involves spreading your Investments across
different Asset classes with the intention of maximizing
returns, whilst at the same time, minimizing risks. This
risk versus return equation needs to be balanced against
your own personal Investment situation; for example,
your years to retirement.
There are many assets
classes one can choose from, ranging from the
conservative (cash and bonds) through to the aggressive,
such as Emerging Markets Stocks and Futures. Each class
will deliver a certain mix of risk versus reward. For
example, cash offers very little Investment risk, but at
the same time, little potential Investment
upside On the
other hand, Stocks have historically delivered much
better returns. For example, from from 1982 to 1997,
stocks delivered a total Real Return of 12.8% (Real
Return being nominal return less Consumer Price
Inflation (CPI). Even higher returns were experienced
near the end of the recent Bull Market. However,
and as has been made painfully clear to many people over
the past year, investing in the stock market DOES carry
risk. This would have been particularly evident to
people that had piled up on Technology stocks hoping to
participate in the 100+% gains sometimes
experienced by Investors at the peak of technology stock
buying frenzy. Many of these Investors eagerly chased
individual stock selection tips from friends,
newsletters and media programs like CNBC. Everybody
became a Stock Picking expert overnight!
The Online Broking Industry did a great job in heavily
promoting the virtues of being an Online Investor. They
spent hundreds of millions of dollars per year promoting
Investors to trade speculatively and often. In many
cases, these advertisements reinforced cognitive biases,
such as overconfidence. More on this later. Most
advertising also created unrealistic expectations in
regards to levels of expected risk and return. For
example, one online broker ran advertisements showing a
truck driver owning his own Island.
At the peak of the frenzy, Securities Exchange
Commission Arthur Levitt issued a statement
expressing his concern at the effects this advertising
may have on Investors. His main concern - "I’m
worried these commercials step over the line and border
on irresponsibility".
But like in all speculative Bull Markets run ups, the
good times ended - with a thud ! The NASDAQ Index
fell over 60%
from March 2000. Many tech laden Investors have seen their
Investment Portfolios decline by similar amounts. Online
Investing advertisements have all but disappeared as
burned investors slow their trading activity down, or
stop trading altogether ! This
large market correction experienced in the Technology
Sector has highlighted one of the fundamental reasons
behind the need for Investors to apply asset allocation
techniques - Diversification. In layman's terms,
Diversification can be translated into 'Don't put all
your eggs in one Basket'. By limiting their exposure to
technology stocks through diversification techniques, an
Investor would have limited their loss of capital during
the correction. Academic
proof of the undeniable benefits of Asset Allocation can
be found in a Study of 91 large pension funds over a
10-year period, by Gary P. Brinson, L. Randolph Hood and
Gilbert L. Beebower, "Determinants of Portfolio
Performance," Financial Analysts Journal,
July-August 1986.
This study showed that Approximately 94 percent of variability
of a fund's investment return is due to asset
allocation 
It
also showed that Stock selection and Market Timing
accounted for only 4% and 2% of Portfolio returns respectively.
This
study had profound implications on Wall Street. Initial
reaction, not surprisingly, was to discredit the
findings. After all, the findings suggested that only 6%
of a portfolio's returns could be attributed to skills
that Wall Street firms prided themselves on - Stock
Selection and Timing. Could it be true that their huge
research departments, and their related costs burdened
on Investors, added no value/returns beyond what an
Investor could attain through passive Index Fund
Investing ?
Lesson 2 - Historical Asset
Returns
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