294 Chapter 6 Investments
want to allocate all of his money to equities. But that rate of return does not come with a
guarantee; rather, it comes with a high degree of risk, and the near certainty that, even if
the journey ends with the hoped for rate of return overall, it will be a bumpy ride. An inves-
tor primarily concerned with safety might want to put all of his money into cash. But that
safety comes at the cost of a very uninspiring investment return; cash investments do not
run much risk of losing money, but they don’t risk making much either.
Asset allocation is a matter of balancing the investor’s desire for return with his toler-
ance for risk. A couple trying to save enough money for a down payment on a house that
they hope to buy in a few years does not have the time to ride out volatility or make up for
losses, and their money is not being invested for long enough for compounding to really
work its magic. In their situation, they may choose to allocate most, if not all, of their
money to cash.
A 20-year-old setting aside money for retirement has plenty of time to ride out
any investment volatility, or to make up for any losses along the way to a far-in-the-
future retirement. Having studied business math, she also no doubt realizes that, with
compounding over time, a high overall rate of return will produce much larger future
value. Such an investor may choose to allocate most of her investment dollars to equities.
Yet if she is the type of person who would lose sleep worrying about the stock mar-
ket or, worse yet, buy more when prices are high and sell out when prices are low, she
might choose to lighten up on the equity investments just to be able to sleep at night.
Even in identical financial situations, someone who spends vacations cliff diving will
likely choose a somewhat different allocation than someone whose idea of a wild time is
ordering both an appetizer and desert. Determining the right asset allocation for a given
situation is an art, not a science, and it can have as much to do with personality as with
mathematical formulas.
It is possible, though, to get a sense of the overall rate of return that might be expected
from a given asset allocation. This can be reasonably estimated by a weighted average.
A weighted average is a mathematical tool in which each item being averaged is given a
different importance, or weight, based on how much of the given item is included in the
mix. The following example will illustrate how this can work.Example 6.4.1 On the basis of how long he has until retirement and his comfort
with investment risk, Matt has decided that he wants to allocate the money in his
retirement account as follows: 60% to equities, 30% to fi xed income, and 10% to cash.
If he assumes that each asset class provides the low end of the rates of return shown
in the table above, what overall rate of return would he expect to earn over the long
term? What if he assumes that each asset class provides the high-end rate of return?We calculate the weighted average by using 60% of the equities rate, 30% of the debt rate,
and 10% of the cash rate.Using the low-end returns we get: (60%)(8%) (30%)(4%) (10%)(2%) (0.60)(0.08)
(0.30)(0.04) (0.10)(0.02) 0.062 6.2%Using the high-end returns we get:(60%)(12%) (30%)(7%) (10%)(5%) (0.60)(0.12) (0.30)(0.07) (0.10)(0.05)
0.062 9.8%.According to this, it would be reasonable for Matt to expect that his portfolio will earn on
average somewhere between 6.2% and 9.8%. That is a pretty wide range, but even this is by
no means certain. Again, these fi gures are reasonable guesses, based on historical invest-
ment returns, but there is no way of knowing what will actually happen in the future. His
actual investments might earn a much higher, or much lower, rate of return.If Matt wants to make projections, these rates give him some sense of what sort of rate
might be reasonable to assume. If he wants to be cautious, he might use the 6.2% rate; if
he wants to be optimistic, he might use the 9.8%. A good middle ground might be to aver-
age these two rates and use 8%.