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.
RISK AND THE CRITICAL PATH
actually is right now with where it should be in absolute dollar terms. It is a simple comparison of two numbers: What your invest- ments ought to be worth if you are on target and what they are actually worth at any point in time.
The term critical pathcomes from project management tech- niques first developed in the 1950s known as PERT (Program Eval- uation and Review Technique) and CPM (Critical Path Method).
Complex projects are broken down into a series of separate tasks, each requiring a different amount of time and resources to com- plete. Examples of such projects would be constructing a house, developing a new product, or even making a movie. Some tasks can be done simultaneously (such as wiring and plumbing) but some must be done in a prescribed sequence (wall supports must go up before the roof does). The critical path is the longest sequence of tasks that must be done one after another and represents the min- imum total elapsed time to complete the overall project.
The same concept applies to portfolio management. Assume that you need to earn an average of 10 percent per year to reach your goal in 5 years. By simple projection, for each $100 you start with, you should be at or above $110 at the end of the first year, $121 at the end of the second year, and so on. These values trace the crit- ical path that your portfolio must follow if you are to reach your goal.
Fluctuations in your portfolio do not matter so long as your portfolio stays at or above this critical path. This concept will be discussed in greater detail in Chapter 6.
CONCLUSION
Asset dedication provides returns that are superior to those on all asset allocation portfolios tested. The test portfolios encompass the range commonly recommended by brokers. The time frame examined included 10-year periods spanning most of the twentieth century for which reliable data are available. Not only does asset dedication make sense theoretically, but it also appears to provide superior perform- ance by most measures, including returns, capture ratio, and so on.
Past performance is no guarantee of future success, of course, but the evidence suggests that asset dedication is a certainly a worthy contender that all financial advisers and investors should consider. It may represent the start of a paradigm shift in personal investing strategies. Asset allocation should no longer be considered the only game in town. The rest of this book embellishes these arguments and shows how they relate to the critical path of retirement saving. But the basic ideas presented in these chapters will not change.
Asset Dedication versus Asset Allocation: Historical Comparisons from 1926 91
NOTES
1. The majority of this book was written before year-end figures for 2003 were avail- able, so all tables and figures in other chapters end with 2002 data. However, year- end data for 2003 became available shortly before the book went to press, so the tables in this chapter were updated to reflect 2003 results. Other chapters remained as they were.
2. 1926 is a common stopping point for historical comparisons in investment analysis.
3. Data for analyses came from the Center for Research in Security Prices (CRSP) of the University of Chicago (www.crsp.uchicago.edu) and from Global Financial Data (www.globalfindata.com) as noted in Table 1.1.
4. Returns on stocks, bonds, and cash respectively were based on the CRSP and GFD databases of large-company stocks as measured by the value-weighted S&P 500 Index, intermediate U.S. Treasury bond index, and 30-day U.S. Treasury bills.
5. As will be explained in Chapter 12, the internal rate of return (IRR) is the appro- priate return calculation to use for situations that involve periodic cash flows.
6. Although the scenario tested used the S&P 500 index funds to keep the compar- isons valid and simple to explain, she might well have invested in a small-cap index fund or some other investment that she or her adviser felt would grow even faster.
7. The 40 quarters actually used started with the third quarter of 1990 and ended with the second quarter of 2000.
8. Proponents of asset allocation may claim that cash is needed in order to take advan- tage of market timing, but, as has been already pointed out, attribution studies tend to refute the claim that brokers succeed at timing, at least for the average broker.
9. Results for Treasury bills are not shown here because they are considered the equivalent of cash rather than bonds. Trial tests demonstrated that the results were slightly below the worst returns reported here.
10. The mathematical formula for the standard deviation is = √[∑(X– )2/n], where = standard deviation, X= individual value, = the mean of the population, and n = number of observations. The value of the mean must usually be estimated from a sample, so an approximation of must be made by dividing by n -1 instead of n.