Asset mix is the allocation of a portfolio between asset classes, it
balances return and risk. Returns are a combination of the income from an
investment and the price appreciation over the period. Risk is usually proxied
by the "standard deviation" of returns, how much the return changes
about the long-term average.
Returns are calculated on a nominal (dollar) basis or as "real"
returns, the nominal return less inflation. Inflation is usually taken as the
change in the Consumer Price Index (CPI) over the observation period. Long-term
studies have demonstrated that equities have the highest overall returns over
longer periods of time, but they also have the highest volatility. Bonds have
lower returns, but greater stability. Cash and short-term securities have very
certain returns, but very smaller long-term returns. Other asset classes such as
real estate, mortgages and inflation-linked bonds have different risk and return
patterns. To the extent that asset class returns tend to move together, they are
said to be "correlated". The overall risk of the portfolio can be
reduced by combining asset classes with differing return patterns.
Establishing an Investment Policy
A long-term "investment policy" is usually established based on
the investor's long-term objectives and constraints of the investor. The return
objective is the key variable. A high return objective can only be obtained by
investing in asset classes with a higher return. Based on historical experience,
without constraints equities have by far the highest return. An asset planning
study which sought to obtain the highest overall return would recommend an
investor's entire portfolio be invested in equities.
Investor Constraints
Constraints state the risk preferences of the investor. The time horizon of
the investor dictates the time frame for the investor's portfolio. For example,
since equities have a high long-term return but higher volatility in the short
term, the return from equities very uncertain over shorter time periods. Risk
averse investors (those without the capability of absorbing capital losses)
would have a higher cash and short-term component. Investors with a higher
tolerance for capital risk should favour equities. Investors with a high income
requirement would tend to favour a higher fixed income weighting. |