10.1 percent per year). What if Ms. Smith, realizing that her income would be protected over the next 10 years, had chosen to invest in small-company stocks rather than large-company stocks?
How would asset dedication compare to the asset allocation portfo- lios using small-company stocks for growth? Clearly, the overall returns should all be higher, but does asset dedication continue to dominate?
Table 4.7 shows that asset dedication continues to dominate.Its total return now averages 10.6 percent, and the only asset allocation portfolio that can beat it is 70/30, and then only by a hair (at 10.7 per- cent) if it uses corporate bonds. Recall again that corporate bonds traditionally have higher yields than the government bonds that asset dedication was constrained to use in order to protect Ms.
Smith’s income stream as much as possible. No other asset allocation model beats asset dedication (the 60/40 allocation model ties it using corporate bonds). Figure 4.8 provides a chart of the comparisons.
Note that it tells the same story for small-company stocks as Figure 4.7 told for large-company stocks: Asset dedication works better than asset allocation in nearly all cases. As before, decade-by-decade com- parisons back to 1926 can be found at www.assetdedication.com under the “Research” link.
Table 4.7 Asset Dedication versus Asset Allocation: Comparisons of Average Annual Rates of Return for Combinations of Small-Company Stocks and Various Bond Classes, 1926–2003 Asset Stk/Bnd Stk/Bnd Stk/Bnd Stk/Bnd PortfolioStocksBondsDed.*70/3060/4050/5040/60 4Small Co.Corp10.6%10.7%10.3%9.8%9.1% 5Small Co.Int Gov10.6%10.6%10.1%9.5%8.8% 6Small Co.LT Gov10.6%10.5%10.0%9.3%8.6% Mean10.6%10.6%10.1%9.5%8.8% *Asset dedication used only intermediate-term government bonds in all comparisons. Source:Decade-by-decade results available at www.assetdedication.com (see “Research” link).
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Figure 4.8 Asset Dedication versus Asset Allocation: Comparisons of Average Annual Rates of Return for Combinations of Small-Company Stocks and Various Bond Classes, 1926–2003 Source:Table 4.7.
10.6%10.5%10.3%10.1%10.0%9.8%9.5%9.3%9.1%8.8%8.6%8.3%7.9%7.7%
10.7%10.6% 0%4%8%
12%
Asset Dedication Corp Int Gov LT Gov Corp
Int Gov LT Gov
456456
Corp Int Gov LT Gov
456
Corp Int Gov LT Gov
456
Corp Int Gov LT Gov
456 Stk/Bnd 70/30Stk/Bnd 60/40Stk/Bnd 50/50Stk/Bnd 40/60Stk/Bnd 30/70
87
than some target value. Consider first an example in which the rates of return are different (meaning that the ending values are different). In Figure 4.9, two investors both have starting portfolios worth $600,000. Portfolio 1 is very stable and has a constant 10 per- cent return per year. Portfolio 2 provides a higher return (about 16 percent per year) but has more volatility. By the measures of risk most commonly used in the financial community, Portfolio 2 is a riskier portfolio because it fluctuates more than Portfolio 1, which appears to have no volatility at all.
But is Portfolio 2 really riskier? Notice that it always has a higher value than Portfolio 1. Even when it drops in value, its lowest point is never below the value of Portfolio 1. How can Portfolio 2 be considered riskier than Portfolio 1 if its value is always greater?
Clearly, any risk measure like the standard deviation that would cause a person to reach such a silly conclusion should be judged as misleading at best and dangerous at worst. Standard deviation must be used with full knowledge of its disadvantages as a yardstick.
The actual historical record closely represents this sort of sit- uation. Consider Figure 4.5 again. Note how the rates of return for the decades move up and down for all the portfolios tested, includ- ing asset dedication and all the asset allocation portfolios. The most conservative asset allocation portfolio (30 percent stocks, 70 per- cent bonds) lies at the bottom of the chart and has the least amount of fluctuation. It would thus be considered the least risky as meas-
Figure 4.9
Portfolio 1 versus Portfolio 2—Which Is Riskier?
$2,500,000
$1,500,000
$500,000
$0
$2,000,000
$1,000,000
1 2 3 4 5 6 7 8 9 10
Portfolio 1 Portfolio 2
ured by the standard deviation and other measures based on the standard deviation. Asset dedication has more volatility, but, like Portfolio 2 in Figure 4.9, it nearly always stays above the 30/70 portfolio. How can it be judged riskier?
Now consider an example in which the returns are identical. In Figure 4.10, both portfolios start at $600,000, earn an average return of 10 percent per year, and end at $1,414,769. Portfolio 1 follows a smooth line, and Portfolio 3 fluctuates in value up and down. Portfo- lio 3 has higher volatility and would therefore be considered riskier.
But how much riskier is it really? By definition, risk means that something bad may happen. It is true that the investor with Portfolio 3 would suffer if she had to sell when the portfolio was below the line that represents her target return. But if she sold when it was above that line, she would actually be ahead of her tar- get. It is really only the downward ticks that represent risk. But if the portfolio does not have to be sold, there is no risk to a downward tick in its value. For someone like Ms. Smith who is investing for a 10-year period, the fluctuations of the stocks in her portfolio do not matter. They have no impact. So long as she reaches her target by the end of 10 years, volatility means nothing.
Unfortunately, the standard deviation treats both upticks and downticks as equally bad, whereas common sense correctly assesses upticks as favorable. Furthermore, both portfolios have the same ending value (and thus the same average return). Fluctuations before
Asset Dedication versus Asset Allocation: Historical Comparisons from 1926 89
Figure 4.10
Portfolio 1 versus Portfolio 3—Which Is Riskier?
$2,500,000
$1,500,000
$500,000
$0
$2,000,000
$1,000,000
1 2 3 4 5 6 7 8 9 10
Portfolio 1 Portfolio 3
the ending date are irrelevant. The bottom line is that it may be cor- rect that Portfolio 3 is more volatile, but how this may or may not translate into risk needs to be clearly understood by any investor in order to make the appropriate judgment.
But if you ask your broker how he or she believes risk should be measured mathematically, the knee-jerk response you are likely to receive is “the standard deviation,” without equivocation and without explanation. How many investors make the wrong invest- ment decisions because these fundamental concepts are not explained to them? How many brokers understand these funda- mental concepts well enough to explain them? Nobody knows, but it is easy to fear the worst.
One final note on risk and asset dedication: The income por- tion holds all bonds to maturity, so that portion of the portfolio is taken off the table, so to speak, in terms of risk. Only the portion invested in growth is subject to risk as it is typically measured.
Therefore, asset dedication automatically reduces risk because fewer dollars are subject to the fluctuations. Unfortunately, risk is usually measured as the fluctuations in the rate of return rather than the magnitude of the dollars invested. But with asset alloca- tion, brokers often put clients into bond funds that treat bonds like sluggish stocks, trading them based on what they think will hap- pen to the prices of the bonds in the future. This puts the entire portfolio at risk, rather than just the growth portion.
The many different ways to measure portfolio performance with various combinations of risk and return present an almost over- whelming menu of choices. For extremely large portfolios, such an embarrassment of riches may be a good thing. But for personal invest- ing, the complexity leads more to confusion than to enlightenment.
The ultimate reality is that it is difficult to find a valid com- mon denominator with which to compare asset dedication and asset allocation in terms of risk. Comparing standard deviations or any measures based on the standard deviation appears to be deficient.
From the standpoint of personal investors like Ms. Smith, however, there is a fairly easy way to determine if a financial plan is doing what it is supposed to do. It utilizes a widely known concept called the critical path.