Bonds, stocks, real estate, cash, and short-term securities change in comparative values and in potential return as the economic picture changes. Within asset classes, investors weigh industry sectors depending on the outlook for the economy and the market. International markets offer the prospect for increased returns, but at an increased risk.

Asset Mix

Asset mix is the allocation of a portfolio between asset classes, it balances return and risk. Returns are a combination of the income from an investment and the price appreciation over the period. Risk is usually proxied by the “standard deviation” of returns, how much the return changes about the long-term average.

Returns are calculated on a nominal (dollar) basis or as “real” returns, the nominal return less inflation. Inflation is usually taken as the change in the Consumer Price Index (CPI) over the observation period. Long-term studies have demonstrated that equities have the highest overall returns over longer periods of time, but they also have the highest volatility. Bonds have lower returns, but greater stability. Cash and short-term securities have very certain returns, but very smaller long-term returns. Other asset classes such as real estate, mortgages and inflation-linked bonds have different risk and return patterns. To the extent that asset class returns tend to move together, they are said to be “correlated”. The overall risk of the portfolio can be reduced by combining asset classes with differing return patterns.

Establishing an Investment Policy

A long-term “investment policy” is usually established based on the investor’s long-term objectives and constraints of the investor. The return objective is the key variable. A high return objective can only be obtained by investing in asset classes with a higher potential return. Based on historical experience, without constraints equities have by far the highest potential return. An asset planning study which sought to obtain the highest overall return would, most likely, recommend an investor’s entire portfolio be invested in equities.

Investor Constraints

Constraints state the risk preferences of the investor. The time horizon of the investor dictates the time frame for the investor’s portfolio. For example, since equities have a high long-term return but higher volatility in the short term, the return from equities are very uncertain over shorter time periods. Risk averse investors (those without the capability of absorbing capital losses) would have a higher cash and short-term component. Investors with a higher tolerance for capital risk should favor equities. Investors with a high income requirement would tend to favor a higher fixed income weighting.