And The Winner Is... Stocks, By Several LengthsJeffrey M. Laderman
With the stock market reaching unexplored heights, about the last thing that DeWitt Bowman wants to do is embark on a $4 billion stock-buying binge. But Bowman, the cautious chief investment officer for the $79 billion California Public Employees' Retirement System (CalPERS), has his marching orders. Because of lower interest rates on bonds and the outlook that rates will remain low, the Board of Administration of the nation's largest public pension fund decided to increase its equity investments from 50% to 55% of the fund's assets. "It's hard to implement that with the market so high," sighs Bowman, "but we'll do it."
Welcome to the world of asset allocation. Whether we realize it or not, we are all asset allocators--from mega-investors such as Bowman to employees moving money around their 401(k) plans or retirees pulling money out of banks to seek higher returns. Some allocators do it with a pencil and pocket calculator, others with supercomputers. But they're all driving at the same thing: to create a mix of assets that will hit the sweet spot where the investor gets the most return for the least risk.
SOLID FORECAST. BUSINESS WEEK has surveyed Wall Street's leading investment strategists who develop asset-allocation models for their clients. Looking at what these strategists apportion to stocks, bonds, and cash, one thing is clear: Stocks are the favored investment (table). The strategists come to that conclusion through a variety of methods. PaineWebber Inc.'s Edward M. Kerschner employs a totally quantitative approach that uses such information as analysts' earnings forecasts and the current level of interest rates. He then runs it through a computer model that compares relationships on the returns among stocks, bonds, and cash over time. His recommendation: 72% of your assets should be in stocks.
Eric T. Miller, investment strategist at Donaldson, Lufkin & Jenrette Securities Corp., also uses quantitative models, but he may modify his results for variables that can't be reduced to numbers, such as the Washington political scene. President Clinton's standing on Wall Street is now better than it was six months ago, according to Miller, "but the investment community is still suspicious of him."
The most bullish allocation in the BUSINESS WEEK survey comes from CS First Boston Corp.'s Jeffrey M. Applegate, who has put 80% of his stake in stocks, 20% in bonds, and nothing in cash. That doesn't mean he's expecting a runaway bull market for stocks. In fact, his forecast is an 11% total return (appreciation plus dividends) for stocks, which is about the long-term average. But it's nearly double the 6% he expects to make from bonds. Indeed, for bonds to earn any more, interest rates would have to plunge anew, as the result of a bond-market rally. With a solid economy expected in 1994, that's an unlikely event. As for his zero allocation to cash, he says: "In this environment, cash has no investment merit."
INSURANCE POLICY. With short rates on the floor, few strategists would argue with that. But most prefer to keep a little cash just the same. Cash never goes down in value, while stocks and bonds can, so it's a bit of an insurance policy should the markets turn south. Even more, the cash account is where you park money when you have taken profits in one asset and are waiting to redeploy. If investors have been following the strategists' advice, the cash they have raised has come from profit-taking in bonds, not stocks, and it's meant to be spent. Says Charles I. Clough, investment strategist for Merrill Lynch & Co.: "Cash should be looking for opportunity."
If stocks are the asset of choice, why not just buy them and ignore bonds? You could, especially if you're dealing with a retirement plan that you are absolutely sure you won't tap for decades. Stocks are the riskiest of the three basic asset classes, and the year-to-year returns can swing wildly. But the longer your investment horizon, the more stocks you should own. According to Ibbotson Associates, stocks have provided a positive return during 47 of the last 67 years (1926 to 1992). That's 70% of the time. If you look at 58 10-year periods, stocks had positive returns 97% of the time, outpaced inflation 88% of the time, and were the best-performing assets 84% of the time.
True, most pension funds have long-term horizons. But they also have to meet obligations to retirees who are collecting benefits now and will in the next several years. Investors at such funds can't take the risk that stocks will swoon in the short term, even though they may show superior returns in the long run. That's why pension funds hold bonds to create a balanced portfolio.
OVERSEAS ASSISTANCE. But even balanced investors don't stand still. When the outlook for stocks is superior to bonds, as it is now, they may ramp up their allocation to the equity side. These cautious investors, such as the board members at CalPERS, make their asset- allocation changes in small increments. However, because their portfolios are so enormous, a 5% or 10% tilt toward or away from equities or bonds can have a huge impact on prices and the markets. That's why even if you're only investing the funds in your individual retirement account, you have to know how the big investors are moving their money around.
While the basic asset-allocation process uses U.S. stocks, U.S. bonds, and cash, many investors are widening their investment choices. CalPERS' Bowman, for instance, can use privately placed equity and foreign stocks in his overall equity allocation. At the moment, about one-quarter of Bowman's equity investments are in foreign markets, or 13% of the total fund.
Indeed, those who have counted foreign stocks as part of their equity holdings have been richly rewarded over the past year as foreign stocks, on average, have outperformed domestic stocks 3 to 1. In addition, many analysts believe that foreign stocks will beat American stocks again in 1994. Besides potentially higher returns, offshore markets don't move in tandem with Wall Street. "Even if you have a portfolio of different equity mutual funds, you don't really have diversification until you have foreign funds as well," says Edmund M. Notzen, who runs T. Rowe Price Spectrum Growth Fund, a fund which invests in other mutual funds.
Big pension funds and wealthy individuals have high-priced consultants to help them crunch numbers and allocate assets. Individual investors can get help from brokers and financial planners on strategic asset allocation--setting the long-term allocations to meet investment objectives. But there's not much help if they prefer fine-tuning the allocations based on the changing environment.
That's why the Fidelity Asset Manager Fund has grown from $3.3 billion to $8.4 billion this year. The fund's mix now is 46% stocks, 42% bonds, and 12% cash, which is a little lighter on stocks and much heavier on bonds than most strategists. But more than half of the bond allocation is in foreign bonds, which are benefiting from falling interest rates abroad. Half the total portfolio is in non-U.S. investments. The fund is up 21% so far this year--beating the funds and strategists who stayed at home.
U.S. stocks and bonds had near-identical returns in 1993. So as long as allocators stayed out of cash, they did just fine. But 1993 is more the exception than the rule, and how investors divide their assets can spell the difference between a mediocre and a swell year.
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