» Return to Asset Allocation Models
The next step is to examine various possible portfolio combinations to see how they might fit your personal investment profile. Use the risk and return characteristics of the individual categories to help you decide what to emphasize. Then examine the risk and return characteristics of the total portfolio.
The approach is illustrated in Table 3, which presents three portfolios representing different asset allocations, along with returns, growth, income and downside risk.
| Average Annual Return | Average Annual Growth | Average Annual Income | Downside Risk | |
| (%) | (%) | (%) | (%)* | |
| Portfolio 1: | 9.6 | 5.6 | 3.9 | -29.6 |
| 80% stocks, 20% cash | ||||
| Portfolio 2: | 8.6 | 4.2 | 4.2 | -23.2 |
| 60% stocks, 20% bonds, 20% cash | ||||
| Portfolio 3: | 7.5 | 2.9 | 4.6 | -16.8 |
| 40% stocks, 40% bonds, 20% cash | ||||
| * Based on worst returns for one-year holding periods for stocks and bonds, and 0% for cash. All figures are based on historical data; future variation can be expected. | ||||
The figures were derived based on the historical data and the percentage allocated to each category. For instance, the average annual return for Portfolio 1, based on an allocation of 80% stocks and 20% cash, is: [80% × 10.6] + [20% × 4.4] = 9.4%. The downside risk is based on the worst one-year holding period returns for stocks and bonds, and a 0% return for cash (although cash investments always yield positive amounts).
Portfolio 1 is heavily invested in stocks, which indicates that this is a long-term investor with a primary need for long-term growth that outweighs the short-term stock market risk considerations. The overall characteristics of the portfolio reflect the investor's profile: a high tolerance for risk (the downside risk is -29.6%); less emphasis on annual income; and a higher growth return. This portfolio tends to match the characteristics of many individuals in their early- or mid-career stages of the life cycle.
Portfolio 2 offers a more moderate-risk approach, with a downside risk of -23.2%. The trade-off is lower growth.
Portfolio 3 stresses a higher annual income and lower downside risk. The trade-off, again, is a considerably lower growth. This portfolio tends to match the characteristics of many individuals in retirement.
There are many combinations that can match an individual's profile, and everyone's profile differs. The three portfolios presented here are examples to illustrate the approach. Table 4 presents formulas you can use to analyze various combinations yourself, using the historical data. Although the historical data was used as a guide, you should use your own judgment as well. For instance, bear market returns could be used for worst-case scenarios, or recent bond and dividend yields could be used for potential income.
Average annual return (%): _______ = [_________ × 10.6] % in stocks + [_________ × 5.9] % in bonds +
[_________ × 4.4] % in cash
Average annual growth (%): _______ = [_________ × 6.7] % in stocks + [_________ × 0.4] % in bonds +
[_________ × 0.0] % in cash
Average annual income (%): _______ = [_________ × 3.9] % in stocks + [_________ × 5.5] % in bonds +
[_________ × 4.4] % in cash
Downside risk (%): _______ = [_________ × -37.0] + [_________ × -5.1] + [_________ × 0.0]
In addition, keep in mind that at this stage, the allocation process is a rough guide. Don't spend time agonizing over the difference between a 62.5%/37.5% versus a 60.8%/39.2% stock/cash allocation.
With a rough idea of your overall asset allocation, you can start to refine your selections.
