Essential Skills: The Basics of Asset Allocation

Essential Skills: The Basics of Asset Allocation

Today s Agenda What is asset allocation and why is it important Three major asset classes and their associated risks Factors in determining an appropriate asset allocation Asset allocation case studies Suitability issues, including examples Rebalancing Your ongoing role with clients Summary

What Is Asset Allocation? The process of dividing a portfolio among the major asset classes of stocks, bonds, and money market instruments to help manage risk Asset allocation is not diversification

Why Is Asset Allocation Important to Your Clients? Can help them pursue investment goals May help clients to potentially maximize returns while minimizing risk

The Power of Asset Allocation The Potential Impact of Asset Allocation* 4.6% security selection 1.8% market timing More than 90% of the variability in a portfolio s longterm returns may be attributable to asset allocation. 2.1% other factors 91.5% of the variability of portfolio return is due to asset allocation *Source: Gary P. Brinson et al. Determinants of Portfolio Performance, Financial Analysts Journal, May/June 1991.

Three Main Asset Classes High Risk/Return Potential Stocks Bonds Low Cash

A Closer Look at Risk and Return Risk and Return Over 30 Years Ended December 31, 2016 Sources: ChartSource, DST Systems, Inc.; Bloomberg Barclays Capital; the Federal Reserve. Equities are represented by the total returns of the S&P 500. Results include reinvestment of dividends. Bonds are represented by the total returns of the Bloomberg Barclays U.S. Aggregate Bond Index. Cash is represented by yields on 3-month Treasury bills and the Bloomberg Barclays 3-Month Treasury Bills Index. It is not possible to invest directly in an index. Index performance does not reflect the effects of investing costs and taxes. Actual results would vary from benchmarks and would likely have been lower. 2017, DST Systems, Inc. Reproduction in whole or in part prohibited, except by permission. All rights reserved. Not responsible for any errors or omissions. Past performance is not a guarantee of future results.

Expanding on Risk Risk/Return Potential Range of 12-Month Returns Stocks High -43.3% to +53.6 Bonds Medium -3.7% to +18.5% Low +0.0% to +8.8% Cash Equivalents Sources: ChartSource, DST Systems, Inc.; the Federal Reserve. Based on rolling 12-month periods for the 30 years ended December 31, 2016. Stocks represented by the S&P 500 index. Bonds represented by the Bloomberg Barclays U.S. Aggregate Bond Index. Cash equivalents represented by the Bloomberg Barclays 3-Month Treasury Bills Index. It is not possible to invest directly in an index. Index performance does not reflect the effects of investing costs and taxes. Actual results would vary from benchmarks and would likely have been lower. 2017, DST Systems, Inc. Reproduction in whole or in part prohibited, except by permission. All rights reserved. Not responsible for any errors or omissions. Past performance cannot guarantee future results. (CS000132)

Correlation Large-Cap Stocks Correlation Between Different Asset Classes InvestmentGrade Bonds Large-Cap Stocks 1.00 Investment-Grade Bonds -0.03 1.00 Money Market Instruments 0.17 0.65 Money Market Instruments 1.00 Source: DST Systems, Inc. Large-cap stocks are represented by the S&P 500; investment-grade bonds by the Bloomberg Barclays U.S. Aggregate Bond Index; money market instruments by a composite of the yields on 3-month Treasury bills and the Bloomberg Barclays 3-Month Treasury Bills Index. Data is based on 36-month total returns for the 30-year period ended December 31, 2016. It is not possible to invest directly in an index. Index performance does not reflect the effects of investing costs and taxes. Actual results would vary from benchmarks and would likely have been lower. 2017, DST Systems, Inc. Reproduction in whole or in part prohibited, except by permission. All rights reserved. Not responsible for any errors or omissions. Past performance is not a guarantee of future results.

Piecing It All Together What is an appropriate asset allocation for your client??% other?% cash?% stocks?% bonds

Factors Affecting Asset Allocation Decisions Client Goals Time Horizons Risk Tolerance

Understanding Your Client s Goals Retirement? Education funding? Emergency savings? New home? What else?

Goals and Time Horizons 1 year Build Emergency Savings Today 5 years Buy New Home 10 years Put Kids Through College Save for Retirement

Understanding Your Client s Risk Tolerance Time horizon is an important factor Risk tolerance may change over time

Different Allocations for Different Portfolios The Efficient Frontier Source: DST Systems, Inc. For the 30 years ended December 31, 2016. Stocks represented by the total returns of Standard & Poor s Composite Index of 500 Stocks, an unmanaged index that is generally considered representative of the U.S. equity market. Bonds represented by a composite of the Bloomberg Barclays U.S. Aggregate Bond Index. It is not possible to invest directly in an index. Index performance does not reflect the effects of investing costs and taxes. Actual results would vary from benchmarks and would likely have been lower. 2017, DST Systems, Inc. Reproduction in whole or in part prohibited, except by permission. All rights reserved. Not responsible for any errors or omissions. Past performance is not a guarantee of future results.

Sample Goals Type of Goal Example Time Frame Accumulation goals: retirement and college provide funds in more than 10 years Major short-term purchases: home, car provide funds in 2-5 years Wealth preservation: retirement income provide income for 20-30 years Emergency account: unexpected job loss immediate 3-6 months of living expenses

Accumulation Goals Sample goals: retirement and college planning; 10+ years away Asset allocation does not assure a profit or protect against a loss. These examples are hypothetical and used for illustrative purposes only.

Major Purchase Goals Sample goals: purchase home or car; 2 to 5 years away Asset allocation does not assure a profit or protect against a loss. These examples are hypothetical and used for illustrative purposes only.

Wealth Preservation Sample goals: living on retirement income; preserving wealth for 20 to 30 years Asset allocation does not assure a profit or protect against a loss. These examples are hypothetical and used for illustrative purposes only.

Emergency Fund Sample goals: three to six months living expenses Asset allocation does not assure a profit or protect against a loss. These examples are hypothetical and used for illustrative purposes only.

Suitability Issues All general securities transactions must be suitable based on the information provided by a client Information related to Investment Objective and Risk Tolerance must be consistent Trades that appear inconsistent with client needs should not be accepted, unless additional relevant information is provided by the client

Suitability: Example 1 Client age 72 Investment Objective Current Income Risk Tolerance Conservative to Moderate Client instructs rep to liquidate all mutual funds and annuities Use proceeds to buy small-cap stock Is trade unsolicited? Yes Is trade suitable? No May rep execute order? No

Suitability: Example 2 Client Age 55 Investment Objective Growth Risk Tolerance Moderate Current account value $100,000 allocated to a moderate portfolio Client instructs rep to purchase 500 shares of a small-cap stock at $10/share Is order unsolicited? Yes Is order suitable? Yes May rep accept order? Yes A $5,000 purchase represents a small percentage of the overall portfolio, which has a small-cap component

Managing Client Risk Stock Portfolio Asset Allocation Portfolio Annualized return (30 years): 10.16% Risk level: 15.01% Annualized return (30 years): 8.63% Risk level: 9.19% Sample goals: retirement and college planning Hypothetical illustration for illustrative purposes only. Asset allocation does not assure a profit or protect against a loss. Source: DST Systems, Inc. The mixed portfolio is composed of 60% equities, 30% fixed-income investments, and 10% cash. For the 30 years ended December 31, 2016. Equities are represented by the S&P 500 index, fixed income by the Bloomberg Barclays U.S. Aggregate Bond Index, and cash by a composite of yields on 3-month Treasury bills and the Bloomberg Barclays 3-Month Treasury Bills Index. It is not possible to invest directly in an index. Index performance does not reflect the effects of investing costs and taxes. Actual results would vary from benchmarks and would likely have been lower. 2017, DST Systems, Inc. Reproduction in whole or in part prohibited, except by permission. All rights reserved. Not responsible for any errors or omissions. Past performance cannot guarantee future results.

When Should a Client s Allocation Change? After major life changes (new job, marriage, new child) As investment time frames change After major market changes

Drift and Rebalancing Drift Can Expose a Portfolio to Greater Risk Portfolio as of 12/31/1996 Drift can expose a portfolio to greater risk Portfolio as of 12/31/2006 8.6% 10.0% 10.0% 7.5% 4.2% 6.9% 10.0% 70.0% Portfolio as of 12/31/2016 74.2% 10.3% 6.5% 81.8% Source: ChartSource, DST Systems, Inc.; the Federal Reserve; Bloomberg Barclays Capital; Morgan Stanley Capital International. For the 20 years ended December 31, 2016. U.S. stocks are represented by the S&P 500, an unmanaged index that is generally considered representative of the U.S. stock market. Bonds are represented by the Bloomberg Barclays U.S. Aggregate Bond Index. Money markets are represented by a composite of yields of 3-month Treasury bills and the Bloomberg Barclays 3-Month Treasury Bellwether Index. Non-U.S. stocks are represented by the Morgan Stanley Capital International Europe, Australasia, Far East (EAFE ) index. It is not possible to invest directly in an index. Index performance does not reflect the effects of investing costs and taxes. Actual results would vary from benchmarks and would likely have been lower. 2017, DST Systems, Inc. Reproduction in whole or in part prohibited, except by permission. All rights reserved. Not responsible for any errors or omissions. Past performance is not a guarantee of future results. (CS000128)

Rebalancing Considerations Rebalance client portfolios at least annually For retirement plans, rebalance by readjusting make-up of contributions Minimize transaction costs and tax consequences by adjusting new money, not liquidating existing assets Rebalance in tax-deferred accounts when possible Consider using lump-sum payments

Importance of Remaining Proactive With Clients Be aware of clients changing situations How do their current investments mesh with goals, time horizons, and outlook on risk? Being proactive can also foster long-term relationships with clients At the end of the day, it s your responsibility to make sure clients are invested properly

Summary Asset allocation defined Single most important factor in determining the variability of returns in a long-term portfolio. Three main asset classes Stocks Bonds Money market instruments Risk and return characteristics of each asset class Factors influencing asset allocation decisions Client goals Time horizons Risk tolerance

Summary Different allocations for different goals Sample goals Accumulation Major purchase goals Wealth preservation Emergency fund Suitability issues and examples Risk management and volatility Allocation drift/changes and rebalancing

Questions?