Strategic Allocation

Whether an investor is an individual looking to provide for spending during retirement, a pension fund looking to provide future benefits to participants, or an institution looking to provide a long-term stream of operating funds, a central goal of long-term investment planning is to construct a portfolio containing a mix of assets that is well-suited to meet those needs, with an appropriate level of risk.

Two popular approaches for long-term investment planning are "target date" strategies that set allocations to equities and fixed income based on the number of years until retirement, and "fixed allocation" approaches that invest a constant percentage of assets in stocks, bonds, and money-market securities, with little or no variation.

The striking feature shared by these approaches is that the amount invested in stocks, bonds, and other securities has absolutely nothing to do with investment valuations or prevailing market conditions; even if the securities being held are profoundly overvalued or undervalued relative to historical norms. Indeed, the assumptions made by investors and pension funds about likely future investment returns are often set based on average historical returns, even when prevailing market valuations are nowhere near the valuations that produced those historical returns.

Still, while investment valuations are a powerful driver of long-term investment returns, they often have little impact during shorter segments of the market cycle. During recessions or financial crises, risk-aversion among investors can drive already-undervalued markets to even more depressed extremes. In these environments, focusing only on valuations may result in significant interim investment losses or "drawdowns." Conversely, during booms or periods of strong government intervention, speculative pressures can drive already-overvalued markets to even more elevated extremes. In these environments, focusing only on valuations may result in missed returns.

Strategic Allocation takes an integrated approach, by combining two components:

• A value-focused asset allocation component that jointly considers prevailing stock market valuations and interest rates, and aligns the investment allocation with the "preferred assets" estimated to have the highest average annual expected return, adjusted for risk, to each point in a long-term investment horizon, and;

• A risk-management component to adjust exposure during segments of the market cycle where risk-aversion or speculation among market participants may temporarily drive valuations to depressed or elevated levels.

While Strategic Allocation is a disciplined, historically-informed, risk-managed, full-cycle approach to long-term investment, any application of this strategy requires ongoing research and analysis. This is needed particularly because there is no assurance that future market outcomes will adhere to historical relationships between valuations and investment returns.

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