Asset allocation is the centerpiece of any investment plan,
whether it's for an individual or an organization. People typically
set their asset allocation based on traditional assumptions -- many
of which may be badly out of date in today's unusual financial
environment.
Here are four examples of how today's extreme conditions are
rewriting the rules of asset allocation:
1. Don't count on time being the solution to stock
volatility
Financial consultants have traditionally pitched the idea that
while the stock market may have extreme ups and downs from year to
year, that this type of volatility tends to smooth out over the
long term. However, with the S&P 500 hovering at around 1,400
as of early August, it was still below its level of 12 years
earlier.
When it comes to stocks, time doesn't heal all wounds. This
means that people can't be so complacent about their risk levels or
return assumptions, even if they have several years to go before
retirement.
2. Bond yields almost guarantee lower-than-average
returns
It used to be that you could count on bonds for a solid 6 percent
or so a year, simply because of their income yields. Now, with
10-year bonds yielding less than 2 percent, historical return
assumptions need to be radically rethought. True, interest rates
might rise, but the nature of bonds is that their principal value
usually falls when interest rates rise. This makes it virtually
impossible for conventional bonds to get back to their historical
return levels over the foreseeable future. The return assumptions
embedded in many asset allocation programs -- and
retirement savings
assumptions -- need to be reworked.
3. Savings account rates provide stability, but little
else
Savings account rates, along with rates on similar cash-related
vehicles such as money market accounts, have taken an even deeper
hit than bond yields. The good news is that unlike bonds, savings
and money market accounts cannot decline in value, so
savings account rates can benefit right away
if interest rates rise. The bad news is that, in the meantime,
don't expect cash accounts to provide you with much of anything
except stability.
4. Diversification does not guarantee safety
Diversification is a sound principle -- spreading your money around
into different types of investments can reduce your risk. However,
it does not eliminate risk, and in an increasingly interdependent
world, there may be a diminishing benefit to diversification.
For example, foreign stocks were once hailed as a way to
diversify away from exposure to the U.S. economy. Back when
international trade was a much smaller portion of the global
economy, individual economies were much less interdependent. Today,
though, international trade and finance have grown to a level where
most major economies often rise and fall together -- as was clearly
demonstrated in 2008. The lesson is that diversification might help
smooth out routine fluctuations, but under extreme conditions your
risk level is likely to depend very much on the overall economic
exposure of your holdings.
In the past, asset allocation principles have often been used to
put a portfolio on a form of auto-pilot: The thinking was that if
you followed the rules, you'd end up with a normal rate of return
over the long run. Now that so many market norms have broken down,
it may be time to rethink this auto-pilot approach.