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The mix of stocks and bonds can make a significant difference in an investor’s risk-adjusted returns. That’s why it’s wise to focus on asset allocation, Steve Giles tells Joel Dresang in a Money Talk Video. Here is a transcript of their interview.Joel Dresang: Steve, you talk with investors a lot about asset allocation, and you use the efficient frontier. What is that?
Steve Giles: Joel, the efficient frontier is a way to measure your risk-adjusted performance in your portfolio.
Joel: So you can show me, given a certain level of risk, how to optimize my return, based on the mix of investments?
Steve: That’s absolutely right, Joel. In its purest sense, the risk-adjusted performance in your portfolio is going to be determined by that mix between stocks and bonds.
Joel: So Steve, we have some illustrations. Can you walk us through this? Say we started with a portfolio of 100% bonds.
Steve: Joel, a 100% portfolio in bonds is going to give investors the least amount of return but not the least amount of risk. Just by adding a sliver of stocks, 20%, we’re able to reduce your portfolio’s overall risk but increase your return.
Take it a step further. If I increase your portfolio’s stock exposure to 40%, I can’t tell you that I’ve reduced your risk anymore, because I haven’t. But I have given you an incremental amount of return commensurate with the additional amount of risk that we’re taking on.
You go out to 80% in stocks from 40%, now I’ve doubled your exposure to stocks, but I can’t tell you that I’ve doubled your return. Instead, I’ve increased your volatility dramatically.
And carry it out further to 100% stock portfolio; 100% stocks is not going to give you much higher return at all, but you have seen your portfolio’s volatility increase dramatically.
Joel: So, is there a sweet spot on that efficient frontier?
Steve: We have found that much past 55%-60% in stocks, you’re not generating much more in the way of return. All you’re doing is increasing the volatility of your portfolio.
For example, if you were to double your stock exposure from 40% to 80%, you’re not doubling your return. All you’re doing is increasing the volatility that your portfolio is experiencing.
Joel: So if I’m younger, do I have a greater risk tolerance and so I’d go farther out to the right on that curve?
Steve: You know, Joel, a lot of people tell me that because of my age, I should have more money in stocks. I’ve got time to make it back if I lose it.
My response to them is always the same: I don’t want to lose it in the first place.
My portfolio is going to be efficiently allocated between stocks and bonds. I don’t have more than 60% of my 401(k) in stocks, and neither should our clients.
Joel: So what’s the takeaway for investors about the whole efficient frontier?
Steve: The takeaway is that 92% of their performance is going to be determined by that asset allocation. If 92% of my performance is determined by my stock-bond mix, that’s what I’m going to pay the most attention to. Less than 8% can be attributed to stock selection or market timing.
Most people, when we first meet with them, want us to find some fast rabbit to bet on. They want us to find a way to try to time the market. And I have to remind them that 92% of our success is determined by the allocation. That’s what we’re going to focus on.
Steve Giles is vice president and investment advisor at Landaas & Company.
Joel Dresang is vice president-communications at Landaas & Company.
Money Talk Video by Peter May
(initially posted June 5, 2014)
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