Your allocation strategy can make a
major difference to your investment return and your level
of investment risk. That's because each asset
class behaves differently from the others, and the
percentage each accounts for in your portfolio affects
the overall performance.
For example, while stocks can be the most volatile investments
over the short term, they have historically outperformed
every other asset class over longer terms of 10 years or
more. Bonds, on the other hand, often provide a reliable
income, but over time have historically underperformed
stocks. And cash equivalents, though comparatively safe
and extremely liquid usually
provide very modest returns.
For an investor, this means that the greater the percentage
of stocks in your portfolio, the greater your potential
for higher returns over the long term. However, the downside
is that the more stocks you own, the greater your potential
for short-term losses.
Professor
Roger Ibbotson, Yale University, chairman and founder
of Ibbotson Associates
Roger
Ibbotson discusses an important allocation technique
for lowering portfolio risk.
The extent to
which asset
classes perform similarly to one another is called
correlation. Correlation measures the movement of one
asset class relative to another, and ranges from -1 to
+1. A correlation of -1 means that the two assets move
in opposite directions, while a correlation of +1 indicates
that two assets move together. Most traditional asset
classes fall into the moderately positive range in relation
to each other. For example, from 1926 to 2001, the correlation
of long-term corporate bonds to large company stocks
was .23, or moderately positive. For the same period,
the correlation of U.S. Treasury bills to small company
stocks was -.04, or slightly negative. Holding investments
with low to negative correlations to one another can
reduce the overall volatility and risk within your portfolio.
Professor
Roger Ibbotson, Yale University, chairman and founder
of Ibbotson Associates 