Wealth Management Report: Asset Allocation and Diversification

Investors today face bewildering choices about what to do with their money. As market conditions change and new financial products appear and disappear, making sense of information and innuendo about effective ways to manage wealth can be extraordinarily difficult. In this Wealth Management Report, produced in collaboration with the Institute for Private Investors by contributing editor Nina Mehta, Knowledge@Wharton readers offer a variety of perspectives on how they think about asset allocation and diversification. Future reports will focus on topics such as performance evaluation, hedge funds and estate planning, among others.

Making decisions about investments and portfolios is no easy task. Individuals are bombarded with a dizzying array of investment options. Information abounds, advice comes from all quarters, recommendations often contradict one another, and new products and asset classes are invented at breakneck speed. How should investors make sense of the chaos of information and innuendo that exists about wealth management? How should they create a portfolio of investments that will provide sufficient money to see them through life and help them achieve their goals?

While these questions may seem daunting, they are necessary. Indeed, the need to save and invest money for the future is one of life’s certainties, along with death and taxes (and not unrelated to them).

This installment of the Knowledge@Wharton Wealth Management Report, conducted jointly with the Institute for Private Investors  in New York, addresses asset allocation and diversification. Future installments will focus on other areas such as performance evaluation, hedge funds and family matters. For this report, we decided to do something we haven’t done before: turn to our readers for the answers. This was based on the belief that Knowledge@Wharton readers are a bright and insightful lot and that making it possible for them to share their knowledge with one another might be a valuable exercise.

We chose asset allocation and diversification as the themes because these are the cornerstones of modern portfolio theory, which is based on the notion that investors want to maximize returns and minimize risk in their portfolios. The essential idea is that holding assets that are correlated to one another (that is, assets that tend to move in the same direction at the same time) increases the risk associated with a portfolio, while holding assets that are less correlated to one another decreases the risk associated with a portfolio. Risk and return are two sides of the same coin, and investors must determine how much risk they are willing to assume to generate the kind of returns they hope to achieve.

This is a long report, and the responses to the first question — about how an individual should allocate his or her investments across various asset classes — are the lengthiest. We hope this report will be read straight through, however, with perhaps a couple of breaks for oxygen.

Wharton finance professor Richard Marston, who directs a program on private wealth management at Wharton, has a few observations about the responses. He notes that two fundamental questions investors must address, which many of the responses in the report took for granted, are the likely life expectancy of the investor (or couple) and the percentage of assets the person (or couple) expects to spend every year in retirement. In terms of the latter, “If it’s 5%, and bonds are earning 5%, the investor is in trouble,” he says. Why? Because of inflation.

Decisions about what constitutes the right or appropriate portfolio for any investor must balance the spending needs of the individual in retirement against the probable returns on a portfolio. And the investor “must focus on the risk that really matters in retirement — the risk of running out of money before the person dies,” Marston adds.

A word about how the answers in this report were chosen. Some 150 people responded to a survey questionnaire posted on the Knowledge@Wharton website at the beginning of March. Some answered one or two questions, but many provided answers to 10 or more (from a total of 16 questions). Every respondent was assigned a computer-generated individual number. With more than 1,000 answers grouped by question, we went through and selected the best and most interesting responses, editing them as necessary. The selection process was blind; in other words, we did not know whose responses we were choosing, and we did not know how many answers by the same person we were selecting.

The results, we believe, are fascinating. We wound up with responses from about 65 individuals. Three-fifths of them work in the financial services industry, many as financial planners. We were hoping for a mix of professionals who think about these topics for a living, and individual investors who must think hard about these issues in order to plan for their future. We wanted a mix of responses that took a broad-gauge view of the topic at hand and those that provided more concrete, hard-and-fast answers. We wanted informative, sensible, smart and thoughtful answers. And we wanted an occasional bit of levity.

We got all this. We also have a range of voices from different geographic areas. Most of the replies came from individuals in the U.S., but this survey includes responses from people across five continents. From the start, we decided not to include anonymous answers. Every answer (with one exception) is identified by name. In that single instance, a financial planner provided an ironic response, and lest the person’s employer not see the humor, we decided not to reveal the person’s identity.

Indeed, many of the humorous responses we received were enlightening. Some were genuinely funny, but many were the equivalent of individuals throwing up their hands in frustration at being asked to parse their thoughts about some of their investment decisions. Perhaps the humor can be seen as a proxy for how uncertain many investors are about gauging the value of their own decision-making.

Not surprisingly, there is a marked difference in how individual investors and professional wealth managers answered these questions. Their answers are not always dissimilar, but investors have frequently come around to the same conclusions as the professionals. The change is based on their experience or, more likely, as a result of financial loss. This can be seen, for example, in the responses to the question about how often a portfolio should be rebalanced.

For the record, it is safe to assume that those whose comments appear in this report are speaking for themselves and that their opinions do not necessarily reflect the opinions of their firms. This survey is intended to encourage readers to think hard about the hydra-headed business of investing. There is much of value in this survey, but there are also some answers that are off the mark, or that are outliers in terms of the range of other answers. Some of these answers have been included to remind readers how difficult and frightening these life-transforming decisions about investments can be.

Happy reading and good luck!

Question 1:
Assuming the four main asset classes are stocks, bonds, alternative investments (such as real estate and private equity) and cash, how should my investments be allocated if I’m 50 years old? If I’m 65 years old and newly retired?
I think the total amount of the estate (wealth) should enter into the determination of asset allocation, along with the health and the expected lifespan of the individuals. The appetite for risk is another consideration, as is the ability to deal with contingencies. After saying all that, I would allocate 65% to stocks for the 50-year-old and 55% for the 65-year-old. I would use alternative investments only if the total amount was very substantial and the individuals had some expertise in that field. Bonds and cash would be divided so that there would be enough cash for about six months’ spending, with the balance in bonds.
Irwin Danz, president, Benchmark Consultants Inc., Wilmette, Illinois, US
A 50-year-old person can be expected to live another 30-35 years and probably has earned income. Therefore, the person’s assets should be invested for growth at this stage of life, with an asset allocation of 60-70% stocks, 2% cash (assuming the person has three-to-six months’ worth of living expenses set aside elsewhere as an emergency reserve), 15-20% bonds, and 10% in real estate. Private equity exposure generally is limited to very wealthy investors. If the 50-year-old is in that classification, 10% in private equity would be reasonable. A 65-year-old person has a 15-20-year life span. The greatest danger is that the person will outlive his or her assets. Studies have shown that an optimum asset allocation sets aside enough cash for one-to-two years of living expenses, so that, should a severe market correction occur, the person would not have to sell securities at depressed prices. Beyond that reserve, the remaining assets should still be invested with an emphasis on growth: 55-65% in stock, 10% in real estate, and 25% in bonds.
R. Nardi, vice president, Peoples Bancorp, Marietta, Ohio, US
Until recently, my reading taught me that 100 minus my age would tell me what percentage of my assets should be in stocks. However, in the past few years I have read frequently that that is too conservative. With the average life expectancy of someone my age (63) being about 20 years, if I had only 37% of my assets invested in stocks, inflation would likely eat away at my assets, and I would run out. Real estate, from what I see, should be restricted to my house (plus perhaps a vacation house), unless I have the time and skills to manage the real estate I am renting. And in the past, there was a recommendation of three-to-six months’ worth of cash, for emergency purposes, but considering how paltry the earnings are on savings, I think that is too much money to tie up earning essentially nothing. Even six-month CDs are a lot better.
Henry Berman, president, Berman Consulting LLC, Spokane, Washington, US
It depends on how the asset classes are valued relative to their expected discounted future cash flows. Buying investments in any asset class without regard to their expected future return (as opposed to ranges of past returns) because one is a certain age makes no sense to me.
Don Pugh, principal, Valuation Based Investing LLC, Atlanta, Georgia, US
First, tell me more about yourself: Will you lose sleep if your portfolio loses 10-15% of its value in any one of the next 10 or 20 years? Do you have other means to live on if your investments disappear, and could you maintain the lifestyle you desire with those other means? When (in terms of income and time) will you start reaching into your investments to supplement your other income? When you’re 50, assuming you are still working, try 50% equity, 30% bonds, 10% alternative assets, and 10% cash. In addition to some degree of diversification among non-correlated assets, the bonds and cash give you some value stability as well as room to maneuver funds into the other classes if you see a buying opportunity (you’ll recognize it by the fact that you will be awake at 3 a.m. wondering whether or not to bail out of equities). At 65, you’re probably going to need to start drawing on the money, but you still need to keep it alive for as long as you are. Try 40% equity, 30% bonds, 10% alternative assets, and 20% cash. Same reasons for the mix, but with a recognition that your immediate cash needs will still be there but the other income won’t, so it will be on your portfolio to help pull the wagon.
Marc Boone, director, Deutsche Bank, Frankfurt, Germany
The answer to this question is determined by an individual’s retirement plans. My grandfather retired at 82, yet my father died at 65. If you are predisposed to a long life, then stay with higher risk-reward investments later in life. Work with your partner in life to define the income that both of you will require in retirement and develop a plan to achieve this income goal. Determine if you need to augment your retirement income with additional earnings.
Russell King, vice president of supply chain operations, MEBC LLC, Collegeville, Pennsylvania, US 

The answer depends on one’s ability, capacity and need to take risk; there is no single answer. As a generalization, however, I suspect that many retirees, 65 and over, would be comfortable with an allocation of 30-40% stocks, 50-60% bonds, and 10% cash. The very wealthy would probably be comfortable with a greater allocation to stocks (up to 80-90%) and the very unwealthy with a lesser allocation (0-20%). At age 50, I think investors should start to retool their allocations to fit their retirement goals, but a 40-60% stocks, 30-50% bonds, and 10% cash allocation would be reasonable (again, tempered by wealth). My allocation at 72: 40% in passively managed stock mutual funds, 50% in low-cost actively managed bond funds, and 10% in money market funds, CDs and savings bonds.
Richard J. Lay, retired (electrical engineer), Northbrook, Illinois, US
I am 57 years old. I have had several bad (money-losing) experiences having my money professionally managed. At present I have a blend of professionally managed and self-managed stock portfolios. In addition I have been accumulating rental property in a New England resort town. With real estate, the mortgage goes down over time and the equity and rents go up over time. Eventually the equation will shift favorably in my direction and I will be able to retire and collect rent in my old age.
Larry Gotch, president, GTO Products, Darien, Connecticut, US
Limiting investment choices to these four classes ignores an asset that I have marketed for over 30 years: guaranteed fixed annuities. At age 50 the risk of principal loss is acceptable because we have time to get even or ahead. Fixed annuities would therefore be used by only the most risk-averse investor. However, there are now equity-indexed annuities, which let an investor share in the gains of the stock markets with no risk to their principal and a minimum tax-deferred yield as high as 3% annually, compounded for the life of the contract. In addition, with a ratchet design and a reset feature, gains are locked in annually and the measuring index is reset each policy year. This feature means that a drop in the index is rewarded by a lower starting point in the next year. The lifetime guaranteed fixed annuity is a good option for many retirees.
Bob Affronti, president, FSD Financial Services, Tarzana, California, US
I am 56 and have been investing for about four years, after realising that my assets would provide very little in my retirement. I have limited funds but I continually add to them. Because of this, I initially made the decision to invest only in stocks. I have resisted the temptation to invest all of my funds in one company, and have diversified as the funds have grown. I have had success relying on my business acumen and the use of a global perspective when selecting stocks. I have invested in small-cap stocks and resource stocks. I appreciate that these stocks are higher risk and that I stand the chance of losing my capital; however, I am an active investor and have the ability to shift funds quickly if things turn sour. I also realise that theory suggests less-risky plays for someone of my age because there is little working life left for me to grow my capital again. I would like to finish by saying that I am very confident of my technique, though not complacent, and even if I had large amounts of capital, I would still use the same method.
Barry Kennedy, director, Academic Computer Furniture Pty. Ltd., Sydney, Australia
I am a private investor, 59 years old. My wife and I have dollar-cost-averaged into the stock market since 1982 and went to cash only at the end of the fourth quarter of 1999. We have since diversified into I-Bonds, Treasury Inflation Protected Securities and cash. We own no stock. We understand the argument for diversification, but the current macro conditions scare us to death. We feel the best solution to our dilemma is to ladder our cash into five-year Treasuries, holding out six months’ living expenses and $100,000 for investment in options when we feel we understand an investment and believe it has upside potential.
Mike Wyatt, manager of training, Matco Tools, Stow, Ohio, US
There is no canned answer to this question. At 50, with 10-20 work-years left, a significant portion of assets should be in equities, or in cash available to purchase equities if the market is moving down. Equities, or cash available to purchase equities, may be up to 80%. Bonds should be 15%. With extremely low interest rates, a lower percentage of bonds may be appropriate. Cash held in CDs and money market funds would be about 5%. At retirement, the conventional wisdom suggests moving equities down to less than 50%. Again, this depends on the size of the total investment portfolio, the risk tolerance, and the structure of the portfolio. A larger portfolio may have a higher risk profile without jeopardizing a person’s retirement. An appropriate allocation may be 70% equities, 25% bonds, and the rest in cash investments.
Gail Schulz, retired, Berkeley, California, US
If I’m 50, I will be financing the education of my children for the next 10-12 years. Hence I think about 35% of my investments should be in stocks (a mix of appreciating and income-yielding stocks), about 40% in real estate, and the balance spread equally between bonds and cash. At 65, the proportion will be almost the same.
Ganiyu Alao, financial controller, Fidelity Bank Plc., Lagos, Nigeria
I will be 60 in a few months. At 50 I was almost 100% in equities. I have just purchased within my IRA a balanced fund, so my equity exposure is now down to 95%. I plan on keeping more than 75% of my retirement money in equities.
Gerald St. Amand, information services financial analyst, Indianapolis, Indiana, US
The amount of money to be put in these various asset classes depends not on age, but other factors such as marital status, spending requirements, inheritance, the person’ income, and the time that the person is willing to spend managing the portfolio. For instance, a 50-year-old with plenty of money and a well established personal life, who does not have to support others, can invest significantly more in stocks than one who has aging parents to support and a family to look after.
Rajeev Mantri, student, Northwestern University, Evanston, Illinois, US
At 50, assuming retirement at 65, this person has five three-year and three five-year market cycles to retirement. With this many cycles before retirement, most of my clients are style-diversified in large-cap value, large-cap growth, mid-cap and international equities — typically 25% to each asset class. At 65, my clients have their first year of cash flow needs and typically keep one-to-three years’ expenses in a cash cushion, i.e. liquidity in money market funds or laddered Treasuries, with the remainder allocated as above. If the client has become more risk-adverse, we will engage equity managers that have lower risk profiles and possibly a bond manager that holds positions in rising interest rate markets.
Tom Roddy, vice president in investments, Legg Mason Inc., Dayton, Ohio, US
Oversimplification is the easiest way to respond, but in reality, it depends on my net worth, costs to be borne (college expenses, weddings, etc.), insurance position, debts and expected remaining lifetime, plus of course my personal goals (when will I retire?) and life values. That being said, at age 50, assuming I have 10 years to retirement and no remaining major family expenses, am well insured to cover all debts, and will earn enough to continue adding to my portfolio appropriately, then I would target: 50% stocks, 25% bonds, 15% alternative investments, and 10% cash investments. If 65 and newly retired, this would be my target: 25% stocks, 55% bonds, 5-15% alternative investments, and 5-15% cash investments.
Richard Crawford, financial services, Wilmington, Delaware, US
Let’s start with the 50-year-old. The “right” asset allocation for this person is a function of four factors: the value of his or her portfolio today, the amount this person wants to have accumulated by retirement, the number of years until retirement, and the amount he or she plans to save each year in the interim. The interaction of these variables determines the minimum compound annual rate of portfolio return the 50-year-old must achieve to reach his or her goal. The right asset allocation is the one that maximizes the probability of achieving this return while taking on as little risk as possible. For example, someone who plans to retire within five years and is already quite close to his or her goal will probably hold a higher proportion of bonds than someone with the same goals but a much smaller current portfolio. On the other hand, if the latter investor either lowers his or her goals, increases his or her planned saving, or extends the expected retirement date, their portfolios can both have the same asset allocation, with both being considered “right.”Now let’s look at the new retiree. This person’s asset allocation calculation must be based on a wholly different set of variables, including initial portfolio value, target income, expected years of life, and target bequest, if any. For any given set of values for these variables, the odds can be calculated for two critical outcomes: the probability that the person’s goals will be met, and the probability the person will outlive his or her money. It is the interplay between these input variables and the investor’s relative aversion to adverse outcomes that determines the “right” asset allocation. Finally, in addition to the four asset classes you mentioned in your question, this investor may also want to consider annuitizing some portion of his or her capital as part of the asset allocation process.
Tom Coyne, editor, The Index Investor, Providence, Rhode Island, US

Question 2:
Should the allocation change be based on economic conditions?
No, not if I can control my emotions.
David Gonze, senior vice president in finance and technology, Lumbermens Merchandising Corp., Wayne, Pennsylvania, US
No. Nobody can predict the market.
John Miller, chartered financial consultant, Iron Street Securities, Weskan, Kansas, US
In a depressed market, take equities higher.
Gerald Jablonski, executive vice president, Countrywide Securities, Hinsdale, Illinois, US
No. Asset allocation should be based on the individual’s tolerance for risk and investment goals. Varying economic conditions are a component of risk, which means that a properly allocated portfolio already accounts for economic conditions.
Clay Hale, FEMA, Winchester, Virginia, US
Yes, because economic conditions affect the risk and profits expected from each type of investment.
Tudor Enoiu, consultant, KPMG Korea, South Korea
No. That’s the whole point. Economic conditions are cyclical, and you risk buying high and selling low if you change your allocation based on economic conditions. Henry Berman, president, Berman Consulting LLC, Spokane, Washington, US
Maybe use a tactical asset allocation overlay if you can find a good manager, but don’t change the underlying physical mix.
Andrew Baker, managing partner, Tria Investment Partners, London, Great Britain
This reminds me of the old joke: “What do you get when you put 30 economists in a room? Sixty economic opinions.” If you are like the rest of us and have other things to do on a daily basis, you’re going to make all of the right choices at mostly the wrong times. If you hear about changing conditions in the papers or on TV news, you are already too late, so if those are your primary sources of information, you need to consider the old Wall Street saw, “Buy on the rumor, sell on the news.” Better yet, buy when things look bad and sell as they look even better.
Marc Boone, director, Deutsche Bank, Frankfurt, Germany
The primary determinants of a person’s asset allocation are the time horizon for the funds (which takes into account the need for cash flow and withdrawals), an investor’s risk tolerance, and the person’s financial objectives. I would not suggest making a major change based on economic conditions, but an adjustment within a range is acceptable. When economic conditions are depressed, if one keeps one’s asset allocation in the same alignment, the investor is buying more shares at lower prices. As the economy moves forward to a strong stage and prices of securities rebound, one will be selling more highly priced assets. Thus one is buying low and selling high — exactly what should be done.
R. Nardi, vice president, Peoples Bancorp, Marietta, Ohio, US
I don’t believe in precise percentages since needs are too individual, but I’ll tackle this question. No, no, and again, no. Even at 65, the expected lifespan of a healthy individual is 20 years, and it would not be an extreme statistical stretch to say 30 years. Economic conditions are fleeting, and while analysts on Wall Street proclaim every few years that this time it’s different, the basics haven’t really changed drastically. While cash concentrations may fluctuate as interest rates change, the long-term plan should be prepared to allow for these changes, and the basic mix of long-term growth and short-term cash needs shouldn’t change.
Thomas Hull, consulting actuary, Lakewood, Colorado, US
Yes. The right time to invest in the stock market of a particular country is when its recession is over.
Ilkka Karanta, senior research scientist, VTT Information Technology, Finland
No. I rode out the worst two years of my life in 2001-2002, but I was glad to be in equities last year. The allocation should change based on your particular life expectancy (it’s probably better to guess longer rather than shorter).
Bill Cregan, marketing research manager, Ford Motor Company, Dearborn, Michigan, US
While I don’t believe in market-timing, I do believe that one can tweak a portfolio to take into account current economic and market factors (such as not buying a long-term bond before interest rates start to rise).
Karyn Hoffman, financial consultant, Merrill Lynch, Deland, Florida, US
It’s always best to be investing where other people aren’t. But to do that you have to be able to wait two to three years for a return. Buy bonds when everyone is selling them. Buy good stocks when everyone is bailing out of the market. Buy small, well-run companies for optimal returns in any environment. But none of that means you will have a guaranteed good return this year.
Mary Cole, vice president in marketing and strategic planning, Forest Science & Engineering Inc., Norwell, Massachusetts, US
Many years ago I read a book on investment whose author stated simply that in a bull market you cannot make a poor investment and in a bear market you cannot make a good investment. In essence, a rising tide lifts all boats. I think allocation must be based on economic conditions and the length of time before the money is needed. At 59 years of age, I do not trust the current market for stocks or bonds. I believe they are artificially inflated by the Federal Reserve’s actions and may be subject to major swings as fast money is moved rapidly between investments and countries. At my age, I am scared to invest under these economic conditions.
Mike Wyatt, manager of training, Matco Tools, Stow, Ohio, US
In general, shifting allocation weights between asset classes as economic conditions change (a.k.a. market timing) is a losing bet over the long term. While various academic studies have found that, in hindsight at least, asset class returns are conditionally predictable, consistently successful active management based on these theories has proven to be extraordinarily difficult in practice. To begin with, there are different models that can be used to predict future relative returns, so there’s the problem of model uncertainty. Even more important is the emerging realization that financial markets are complex adaptive systems whose behavior is extremely difficult to predict, regardless of the model used.However, experience has also taught me not to be an ideologue on this point. On rare occasions, assets can and have become so substantially and obviously overvalued that a short-term deviation from your long-term asset allocation strategy is warranted (think of the British pound in 1992, or U.S. equities in 2000). Still, those situations are extremely rare, and even then taking action in the face of a crowd heading the other way takes more than a little courage (particularly if your performance is evaluated annually vs. a market benchmark).
Tom Coyne, editor, The Index Investor, Providence, Rhode Island, US
The allocation should be changed based on economic conditions, but should broadly be aligned with the risk tolerance and return objectives of the client. For example, if the stock market is soaring, one needn’t trespass an asset allocation skewed in favor of bond investments in the case of a risk-averse investor. Portfolio rebalancing is also a good way to maintain risk-return parity among various asset classes.
Sridhar Sattiraju, senior manager, ICICI Bank, Hyderabad, India
I believe in setting a long-term strategic allocation as well as a short-term tactical allocation. The strategic allocation gets the client focused on the big picture of how the various investment asset classes perform over time. I like using a tactical allocation (within fairly tight bands of the long-term allocation) to take advantage of insight the client or an adviser might have into sectors. For example, a business owner in the homebuilding industry might feel that a decline in interest rates could create demand for housing. Adding exposure to this sector might be warranted. Another idea might be to overweight value stocks as an asset class if the investor or adviser feels that this year the focus will be on quality dividend-paying companies. Yet another tactical play might be to write calls on an investor’s large-cap stocks to supplement income, particularly if uncertainty in the economic environment has created sizable call premiums.
Lawrence Katz, senior vice president, Wachovia Bank, Boca Raton, Florida, US

Question 3:
If I already have stocks and bonds in my portfolio, what other assets should I invest in? In what proportion?
Depending on the level of diversification among stocks and bonds, those two investment classes should cover most investors. Alternative investments, while offering good diversification and risk-control benefits, tend to be restrictive in their investment structure, with high minimums, infrequent price valuations and tightly controlled liquidity for withdrawals. Cash should be considered in lieu of a portion of fixed income for short-term or unexpected needs.
Valerie Petrone, first vice president, Salomon Smith Barney, San Francisco, California, US
Laddered CDs are a good addition for someone nearing retirement age who wants a conservative, liquid investment, or for someone who wants to use them as a cash-reserve equivalent. Perhaps 10%.
Henry Berman, president, Berman Consulting LLC, Spokane, Washington, US
It depends on an investor’s risk tolerance, the time horizon for the additional funds, and knowledge of other assets. One should never invest in something that one doesn’t understand. Real estate (particularly Real Estate Investment Trusts or a real estate fund) offer diversification through lower correlation with stocks and bonds; these assets are also liquid. I would recommend including a certain amount of exposure to foreign securities, including stocks and bonds in established foreign companies through ADRs, international stock mutual funds or international bond funds. A more limited exposure to emerging markets through mutual funds offers even greater diversification.
R. Nardi, vice president, Peoples Bancorp, Marietta, Ohio, US
If young, invest in yourself through education and self-improvement to provide a job that will help you generate savings. It is not wise to invest in high-cost illiquid assets that have poor returns for the sake of diversification. Collectables and gold are not good investments. You can think of a home as a financial asset, but this generally becomes a non-diversified large asset, and should not be counted upon.
Samuel F. Burkeen, naval architect (US Navy, retired), Reston, Virginia, US
I find that people who have stocks and bonds in their portfolios are typically overweighted in stocks and need to rebalance; their bond mix tends to be yield-driven with little consideration given to risk and the standard deviation of this asset class. When I rebalance this type of portfolio, I will engage style-diversified large-cap value, large-cap growth, mid-cap and international equity managers, typically 25% to each asset class, and, if needed for risk reduction, an intermediate-term investment-grade bond manager.
Tom Roddy, vice president in investments, Legg Mason Inc., Dayton, Ohio, US
It is always important to add non-correlated assets such as managed futures and alternative investments to lower the overall beta and standard deviation of your accounts.
Tucker Brown, senior financial adviser, Merrill Lynch, Plainsboro, New Jersey, US
Real estate, at least to the tune of 25% of your portfolio. And if you have more funds, then art (preferably art that appreciates) to brighten up your house. If there is more, then invest in a small up-and-coming company with a good idea, assuming you don’t mind waiting some time for the rewards.
Shanth Mannige, director, AccelTree Software Pvt. Ltd., Pune, India
Real estate is a good investment. REITs are the best vehicle for the average investor since they are highly liquid and can be bought and sold just like equities. I also recommend having cash in the portfolio for emergency purposes. Perhaps 5-10% is a reasonable allocation.
Shikhar Bajaj, senior valuation consultant, Wharton Valuation Associates, Plainsboro, New Jersey, US

Question 4:
How should tax considerations affect my asset allocation? What kinds of assets are most tax-efficient?
If one has both taxable and tax-deferred accounts, taxable investments like government and corporate bonds and preferred stocks should be in the tax-deferred account; tax-advantaged investments like stocks (given current favorable rates for long-term capital gains and dividends) and municipal bonds should be favored in taxable accounts. But ultimately, the objective should be the highest after-tax total return. Tax considerations shouldn’t override investment considerations.
Don Pugh, principal, Valuation Based Investing LLC, Atlanta, Georgia, US
All asset allocations should be made with careful consideration of tax consequences. Seeing deferred annuities placed in non-taxable accounts makes me weep. For wealthy individuals and families, private-placement life insurance has interesting generational-transfer implications too. Of course, the most tax-efficient assets are those that give you the highest after-tax return.
James Pope, senior vice president, Sentinel Real Estate Corp., New York City, US
Most people have a great majority of their investments in retirement plans. So current taxes are not a consideration. If they have non-retirement assets, they should have a portion invested in qualified dividend-paying investments to get the tax break associated with them.
John Miller, chartered financial consultant, Iron Street Securities, Weskan, Kansas, US
Now that I’m in the upper income bracket and with the changes in tax laws, I’m having to consider the impact of the rule that requires withdrawals from my tax-deferred vehicles the year after reaching age 70.5. For folks who have large 401k and IRA amounts, this can be a major pain. When you do the numbers with the lower capital gains taxes, it seems to make sense to take advantage of the five-year holding period on taxable gains rather than take the big hits at 70.5.
Gene Cartier, vice president, SRA International, Fairfax, Virginia, US
It’s more about tax strategy within allocations rather than the allocation itself. For example, within equities, high-rate taxpayers should avoid high-turnover mutual funds and unit trusts, which create a lot of short gains and few tax-deferred long gains. High-rate taxpayers will also have a low-ish exposure to bonds and cash (which I recommend anyway) and might even replace them with low-volatility assets such as funds of hedge funds.
Andrew Baker, managing partner, Tria Investment Partners, London, Great Britain
First, you really need to look at where you put your assets and how often you move them around or turn them over, as those will be the primary drivers of tax consideration for most of us. In other words, stuff the money into tax-deferred accounts (401k, IRA, etc.) on a pre-tax basis to the maximum extent possible — when you look at the returns on post-tax plans that draw on capital gains treatment at liquidation, they generally have better internal rates of return (an estimator of growth over time) than pre-tax plans with income tax treatment. However, if you boil both down to net present value (real cash today), the pre-tax plans are consistently better.Second, if you want to minimize taxes on your portfolio, don’t do too many tax-inducing transactions. Reduce the turnover, and make sure that your holding periods are long enough to qualify for better rates. But don’t hold on for a tax break at the expense of your well being. Choose an exit point, perhaps -10%, and take the exit rather than watch your assets melt down simply to get a better tax rate. The point is that if your assets are crossing the -10% threshold, they are heading in the wrong direction.
Marc Boone, director, Deutsche Bank, Frankfurt, Germany
I don’t worry about taxes. I suppose I should. If make a profit, my partner the government makes one too.
Larry Gotch, president, GTO Products, Darien, Connecticut, US
The answer depends on the national jurisdiction. For instance, in South Korea investment in overseas securities (including mutual funds investing in overseas markets) are not subject to taxation in Korea, while dividend income of corporate shareholders is generally not subject to multiple taxation.
Tudor Enoiu, consultant, KPMG Korea, South Korea
Asset allocation decisions should be based primarily on an investor’s time horizon, risk tolerance and financial objective. Once the allocations to major asset classes have been determined through a valid questionnaire process, then tax considerations should be considered. For a tax-conscious US investor in a 25% or higher tax bracket, tax-free bonds should be used for the fixed-income segment. Tax-free bond yields today are very rich compared to taxable yields and offer great appeal, even at these low rates. Based on the recent tax law change that allows for a 15% tax on dividends and capital gains, stocks are very appealing for tax-conscious investors. Individual stocks, as opposed to stock mutual funds, allow an investor to control the timing of capital gains. That, plus the 15% on dividends, makes stocks more appealing than taxable bonds.
R. Nardi, vice president, Peoples Bancorp, Marietta, Ohio, US
Generally speaking, taxes should rank lowest in your concerns about asset allocation. Taxes do play a role in where the assets should be held. Bonds and shares in REITs should be held within a tax-deferred account (IRA, SEP IRA, 401k, etc.) whenever possible, since the interest or dividends on those investments are treated as ordinary income. After that, mutual funds paying out high short-term capital gains should be held in tax-deferred accounts. Stocks, cash, municipal bonds, shares in master limited partnerships, and hard assets that don’t produce much in the way of short-term capital gains or taxable interest should be held outside those accounts.The most tax-efficient investment is a common stock that you don’t sell. Following that, municipal bonds (particularly from your home state if you live in a state with a high income tax rate) and non-income-producing hard assets (gold, silver, etc.) are highly tax-efficient. Depending on your personal situation, shares in timber or oil and gas partnerships are often highly tax efficient, since much of your current income is treated as return of capital, and thus isn’t taxed until you sell.
Clay Hale, FEMA, Winchester, Virginia, US
My wife and I recently realized that we have been suckered into investing primarily within our 401k’s and IRAs, creating a future tax burden. We are currently buying individual municipal bonds to fund our very old age. We plan to use our taxable savings first. Returns greater than our current needs will be invested in additional munis.
Mike Wyatt, manager of training, Matco Tools, Stow, Ohio, US
Tax considerations should be very prominent in considering which assets to place in qualified and non-qualified accounts. For example, individual growth/value stock investing in IRAs for tax protection is my preference as opposed to in a non-qualified brokerage account. Placing a preferred stock or high-yield utility stock or fund in my non-qualified accounts is the other side of the coin. I like dividend-paying assets for non-qualified accounts now. Also, when I’ve maximized my tax-protected vehicles and have assets, I’ll consider a low-cost annuity.
Richard Crawford, financial services, Wilmington, Delaware, US
Although your marginal tax bracket may influence your decision, my philosophy has always been to assess the value of the underlying asset and not to rely solely on the tax implications. That said, I believe individual growth-type stocks are generally the most tax-efficient investments since you can control when they are acquired and sold and you can benefit from the long-term capital gains tax.
Robert E. Shuman, member of technical staff, Lucent Technologies Inc., Naperville, Illinois, US
The return on every investment must be done on a net, after-tax basis. If my investment is subject to income tax vs. capital gains tax, the net to me is the only valuable rate of return. Life insurance is a very tax-efficient investment — there is no income, capital gains, gift or estate tax, if properly structured — but you pay a big price (death) in order to realize the tax efficiencies.
John Bromley, senior vice president, Burnham Insurance Group, Battle Creek, Michigan, US
Taxes should be of great concern in devising an asset allocation. Traditionally, high turnover, tax-inefficient products and asset classes are used in tax-sheltered and retirement accounts, while more tax-efficient placement is in taxable savings accounts. The decreased capital gains tax on dividends (to 15%, given that holding periods and company qualifications are met) has sparked greater interest in dividend-paying stocks, particularly in today’s low interest rate environment, where a 3-4% yield is attractive. Index investments remain the most tax-efficient due to their inherent low turnover, resulting in few capital gains for investors to pay taxes on. Within this category, exchange-traded funds offer the most flexible and efficient characteristics. Traded intraday like stocks, long or short, yet diversified like index mutual funds, they offer investors tax-efficient vehicles with which to create a completely globally diversified portfolio.
Valerie Petrone, first vice president, Salomon Smith Barney, San Francisco, California, US
Generally, I do not consider tax considerations per se except to compare all returns on a tax-adjusted basis. Thus, a higher-yielding security would be preferable to a security with a tax-free return if the taxable return after taxes is greater than the tax-free return. In terms of tax efficiency, US municipal bonds can be triple tax-free if you buy and hold bonds from the state of your residence. Treasuries are not state-taxable. Also, because of the reduction in the individual tax rate for dividends, high-yielding equities are not tax-preferable to high-yielding debt instruments. Finally, holding individual securities (stocks, bonds, etc.) are generally more tax-efficient than mutual funds since you decide when capital gains are realized.
Shikhar Bajaj, senior valuation consultant, Wharton Valuation Associates, Plainsboro, New Jersey, US

Question 5:
How often should I rebalance my portfolio? It seems counterintuitive to sell assets that are rising, although I know the purpose is to lower risk. Is it more important to do this when the market goes up, or down?
About as often as you should bathe a dog: yearly is probably adequate, especially if you consider tax and transaction expenses. And be reasonable. Tweaking your portfolio 5% may not be worth it, but a 25% rework is. Up and down.
Cooper Abbott, Raymond James Financial, US
I’ve seen recommendations to rebalance annually. If I had done that, the big bear market would not have hit me so hard. It always seems that this time it is different, but it never is. It is important to rebalance regularly. Also, if you inherit a lot of money or are forced to retire much earlier than you expected, you may need to rebalance.
Henry Berman, president, Berman Consulting LLC, Spokane, Washington, US
The really successful investor backs winners at the expense of a balanced portfolio. Run your winners, dump your losers. The core difference between winners in a rising market and a falling one is that the latter are likely to be better investments over the long term, since they are more likely to be value stocks.
Michael Furse, Maunby Investment Management Ltd, Great Britain
Studies have shown that regular balancing of one’s portfolio has provided the best total returns over time because one is selling assets at higher prices and buying assets at lower prices. Many investors wish that they had rebalanced their portfolios during the bull market of the mid-to-late 1990s, selling technology stocks in particular at highly inflated prices and buying stock during the bear market at greatly reduced prices. I would recommend looking at one’s portfolio quarterly and rebalancing whenever a sector is over or underweighted by 5% or more. More frequent rebalancing can increase turnover, which has been shown to have a negative impact on total return. It can also increase trading costs and capital gains.
R. Nardi, vice president, Peoples Bancorp, Marietta, Ohio, US
The answer to this question depends on whether you think of asset allocations as being highly defined or in ranges. Assuming normal transaction costs and some influx of assets to the portfolio, rebalancing can be done by the allocation of new cash. If the portfolio is static in terms of assets (other than value changes), I would think that quarterly or semi-annual rebalancing is amply frequent.
James Pope, senior vice president, Sentinel Real Estate Corp., New York City, US
I don’t believe in concepts like arbitrary asset allocations and rebalancing. Investments should be held as long as they appear to offer attractive future returns and sold when they don’t. If you don’t understand the value of the investments you own, rigid asset allocations and rebalancing rules won’t protect the purchasing power of your portfolio.
Don Pugh, principal, Valuation Based Investing LLC, Atlanta, Georgia, US
Step one is to create a diversified portfolio that will protect you over time. If one position in your portfolio becomes predominant, then it makes sense to reinvest a part of the gains from that holding to preserve gains. The next question becomes what to invest in next. If the stock that you are taking gains on is expected to continue to rise, you can reinvest with a new basis. This protects your gain with a reentry at market price. It is always helpful at tax time to have a loss to offset the gain.
Russell King, vice president of supply chain operations, MEBC LLC, Collegeville, Pennsylvania, US
At a minimum, an individual’s portfolio should be analyzed annually, weeding out the poorly performing stocks, reassessing one’s slant to either growth or value stocks. Depending on market volatility, it is possible to do this throughout the year. Monitoring when the market is in freefall (going down) is most important. The easiest way to minimize your exposure is through the use of stop-loss values that you have previously determined.
Marian Vasjuta, systems analyst, Origin Energy Ltd., Melbourne, Australia
Think of the markets as a two-way street — and like your mother probably used to say, always look both ways before crossing. Rebalancing is a good way to take some money off the table when times are good and assets are expensive, so that you have money to invest when they are not and assets are cheaper.
Marc Boone, director, Deutsche Bank, Frankfurt, Germany
No more frequently than every year, to avoid short-term capital gains taxes and to minimize any commissions paid. Not less often than every two years. It is equally important to rebalance regardless of whether the market is up or down, since rebalancing is designed to take advantage of relative performance rather than absolute performance. In other words, you are shifting from an asset class that has performed relatively well to an asset class that has performed relatively worse. When your portfolio drifts away from its target asset allocation, you are in danger of not meeting your goals. Additionally, it’s important to remember that while it might seem counterintuitive to sell rising assets, if you are talking about a retirement portfolio, your goal is to participate in the market’s gains in order to retire with some degree of security, not to beat the market.
Clay Hale, FEMA, Winchester, Virginia, US
Although it seems counterintuitive to sell assets or managers that have recently performed well, rebalancing remains a powerful way to reduce risk over the long term, ensuring that an asset allocation remains appropriately matched to the investor’s objective and risk tolerance in the face of market volatility. For taxable investors, semi-annual or annual rebalancing has proven to be the most effective, given trading costs and tax implications. Institutional investors can benefit from quarterly rebalancing that is based on allocations exceeding their policy allocation guidelines or on asset classes whose standard deviations have exceeded their expected ranges. Though it is equally important to rebalance in up and down markets, investors tend to be at greater risk in up markets, where run-ups in some asset classes or sectors can skew the portfolio’s total expected risk well beyond an investor’s comfort level.
Valerie Petrone, first vice president, Salomon Smith Barney, San Francisco, California, US
Reviewing your portfolio’s performance and rebalancing it back to your target asset class weights is one of those ideas that sounds great in theory, but in practice can get you into trouble if you’re not careful. To begin with, given the estimation errors in the input variables that inescapably underlie asset allocation analyses, rebalancing’s benefits are at best approximations; on the other hand, the transaction and tax costs they incur are quite real. That alone argues for being careful about rebalancing too often.Consider two extreme approaches. In the first case, the portfolio is rebalanced to equal asset class weights on a daily or weekly basis. In the second case, the portfolio is never rebalanced; its asset class weights simply vary over time in line with changes in their respective market capitalizations (a strategy that research suggests is used all too often in many 401k accounts!). In effect, the essence of the first strategy is to sell winners and buy losers (call it “extreme value”) while incurring very high transaction and tax costs, while the second does just the opposite (call it “extreme momentum”). Intuitively, most people sense that the best approach is probably somewhere in between these two. To put it a bit more formally, most people sense that both value (i.e., the idea that asset returns tend to revert over time to their long-term average) and momentum (i.e., the idea that returns tend to continue in the same direction) both contribute to long-term asset class returns, though to varying degrees from year to year. Moreover, it is always a good idea to try to minimize transaction costs and taxes.When you think about it, this intuition makes sense. Mean reversion in financial markets reflects the operation of real economic processes at the firm level, where companies often earn high returns following innovation, which are subsequently eroded as competitors either copy them at lower cost or introduce even newer offerings themselves. In contrast, momentum in financial markets is solidly grounded in individual investor psychology. It is widely recognized that it takes far less information to form an initial opinion than it does to change it. Moreover, once formed, an initial opinion affects not only the information to which attention is paid, but also the weight given to it. Both of these factors cause individuals to be overconfident about the accuracy of their forecasts for the future (e.g., a belief that a security or market will continue to deliver high returns).Given these findings, portfolio rebalancing is essentially a risk management tool, in which you are trying to manage this balance between value, momentum, and transaction and tax costs so as to maximize your return per unit of risk. In deciding on a rebalancing strategy, the real challenge is how to optimize your exposure to gains from both momentum and mean reversion, while limiting transaction costs and taxes. There are a number of different rebalancing triggers, based either on time (e.g., rebalance every year back to your target asset class weights) or on relative-valuation levels (e.g., rebalance only when one or more asset class weights is more than 10% above or below its target weight). For investors with lower target returns (and therefore more conservative asset allocation strategies), a simple annual rebalancing approach works quite well. However, for investors aiming for higher target returns, it makes more sense to use a relative-valuation-based approach.
Tom Coyne, editor, The Index Investor, Providence, Rhode Island, US

Question 6:
With interest rates so low and the stock market perhaps overvalued, where should I be allocated today?
There is no one answer, based on age or any other single factor to best determine an individual’s allocation. Some would argue the market is not overvalued. Others would look to foreign markets whose stocks are priced at lower valuations relative to the US, or to asset classes that don’t correlate with the broad stock market. If one is concerned about inflation, then an inflation-protected security might make sense. If one is committed to long-term investment in equities, then a broadly diversified US and international allocation, including emerging markets, might be suitable. Asset allocation should consistently be based on an individual’s time horizon for investing, cash flow needs, appetite for risk, return expectations, and personal investing philosophy.
Valerie Petrone, first vice president, Salomon Smith Barney, San Francisco, California, US
Cyclical stocks rather than non-cyclicals, value stocks with defensive characteristics rather than growth plays, corporate rather than government paper, sterling or the euro rather than the US dollar. Income is good, and dividends can generate a much better return than bank or bond interest.
Michael Furse, Maunby Investment Management Ltd, Great Britain
You need to go back to your objectives: Are you investing for income or for growth? That will be the main driver of your asset allocation. If you are investing for income, you should limit the maturity of the bonds in the portfolio to about four or five years, because impending rate increases will have a greater negative impact on longer bonds than on shorter bonds. Yields on tax-free bonds are attractive relative to yields on US Treasuries. Callable or step-up US government agencies are more attractive than straight agency bullets or Treasuries. I would steer away from preferred stocks that offer relatively high yields because of the long maturity of trust-preferred stocks and the unlimited maturity of older issues of preferred stocks. They could be impacted similarly to long bonds when interest rates rise.A new exchange-traded fund, DVY (the Dow Jones Select Dividend Index), comprises the 50 highest-yielding stocks that meet a certain size requirement. The yield is about 4% and would be taxed at the 15% dividend rate. This is an attractive investment today. You should also consider a heavier allocation to foreign securities. Between anticipation of a cut in interest rates abroad and the weak US dollar, US investors in foreign securities can find attractive potential returns. The outlook for high-yield bonds is still positive through this year, and they offer above-average yields.
R. Nardi, vice president, Peoples Bancorp, Marietta, Ohio, US
I believe in buy-and-hold, stay-the-course investing. One will never be able to correctly predict the mood swings of the market. I believe that with interest rates this low, investors should limit their exposure to long- and intermediate-term bond funds. Short-term funds are a much safer place to be in this current environment. Other than that, I believe most people should rebalance and stay the course.
Kimberly Trapp, owner, Kimby Inc., Miramar, Florida, US
It depends on the client’s situation, goals, age, etc. If I am investing someone in fixed income right now, I would stay to the short end on bonds, bonds funds, etc., to protect against rising rates. If buying individual stocks, I would look for companies with relatively low P/Es, dividend payers, etc. Long-term investors still believe it is better not to try to time the market.
Karyn Hoffman, financial consultant, Merrill Lynch, Deland, Florida, US

Note: The full version of this report is available to anyone who gives a tax-deductible donation of at least $10 — larger gifts are welcome from those who can afford to pay more — to Knowledge@Wharton. It contains answers similar to the ones above to the following questions:

1. What percentage of a family’s net worth should be dedicated to residence? Is it 5%, 20% or more?

2. I need to have a fair amount of cash on the sidelines for about two years and am considering adding Treasury Inflation Protected Securities (TIPS) to my investment portfolio as a cash substitute. Is this wise?

3. How do I know when my portfolio is diversified enough?

4. I have heard that we’re in a stock picker’s market. Does that mean passive, or index, investing is less attractive today? When does indexing make the most sense? Does the answer depend on the asset class?

5. I understand that equity markets are more correlated today than they used to be, so the diversification argument for investing internationally is not as strong. Are the reasons for investing internationally still valid today?

6. I own stock in 200 companies. Is that necessary for diversification, or can I just own 20 or 30?

7. How should I invest in stocks — directly in individual stocks, through a mutual fund, or through a separately managed account?

8. Because of terrorism concerns, I have a higher percentage of funds in municipal bonds and cash than I would have four years ago. Is that the right thing to do?

9. What should I be asking my adviser about the riskiness of my portfolio?

10. How do I know what kinds of risk I’m exposed to? What should I be doing in an ongoing fashion to manage this exposure?
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