The Asset Allocation Decision for Physician Investors

A Historical Perspective for all Lay and Medical Professionals

By Manning & Napier, Inc.


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To a large extent, your investment objectives are driven by your investment time horizon and the needs for cash that may arise from now until then.  Once these objectives have been set, you must decide how to allocate assets in pursuit of your goals.  Establishing the appropriate asset allocation for your portfolio is widely considered the most important factor in determining whether or not you meet your investment objectives.  In fact, academic studies have determined that more than 90% of a portfolio’s return can be attributed to the asset allocation decision.  The following will provide a historical perspective on the risks which need to be balanced when making the asset allocation decision, and the resulting implications regarding the way this important decision is made by investors today.

The Balance between Growth and Preservation of Capital

The asset allocation decision (i.e., identifying an appropriate mix between different types of investments, such as stocks, bonds and cash) is the primary tool available to manage risk for your portfolio.  The goal of any asset allocation should be to provide a level of diversification for the portfolio, while also balancing the goals of growth and preservation of capital required to meet your objectives.

How do investment professionals make asset allocation decisions?  One way is a passive approach, in which a set mix of stocks, bonds and cash is maintained based on a historical risk/return tradeoff.  The alternative is an active approach, in which the expected tradeoff between risk and return for the asset classes is based upon the current market and economic environment.

Can any single mix of stocks, bonds and cash achieve your needs in every market environment that may arise over your investment time frame?  If such a mix exists, then it is reasonable for you to maintain that particular passive asset allocation.  On the other hand, if no single mix exists that will certainly meet your objectives over your time frame, and then some judgment must be made regarding the best mix for you on a forward-looking basis.  This case implies that some form of active decision making is required when determining your portfolio’s asset allocation.  To answer this question, let’s consider the historical tradeoff between the pursuit of growth and the need to preserve capital over various investment time frames.

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The Need for Growth

Our first conclusion is that you have to be willing to commit a majority of your assets to stocks to pursue capital growth, but even an equity-oriented portfolio is not guaranteed to meet your growth goals over a long-term time period.  To provide some historical perspective using Ibbotson data, a mix of 50% stocks and 50% bonds provided an 8.9% annualized return from 1926-1998, but failed to surpass what many consider to be a modest return of 8.0% in approximately 49% of the rolling ten and twenty year periods over this time.  In fact, a portfolio of 100% stocks provided an 11.2% annualized return, but failed to surpass 8.0% in almost 1 of every 3 ten-year periods and more than 1 of every 4 twenty-year periods.

This data also reflects the difficulty through history of consistently achieving an 8.0% rate even with an aggressive mix of stocks and bonds.  In this time of high flying stock markets, it is important to keep in mind that taking more risk is no guarantee of higher returns.  However, what is clear from this data is the importance of allowing a manager the flexibility to achieve meaningful exposure to stocks in attractive market environments to pursue the goal of long-term capital growth.

The Need for Capital Preservation

Of course, there is a clear risk of long-term declines in an equity-oriented investment approach, especially for a portfolio dealing with interim cash needs (e.g., a defined benefit plan with ongoing benefit payments, a defined contribution plan with participants having different dates until retirement, or an endowment with ongoing withdrawal needs).  An illustration of the sustained losses that may result from heavy allocations to stocks is the fact that 1 of every 4 one year periods and 1 of every 10 five-year periods resulted in a loss for a portfolio of 100% stocks.  Even the 50% stock and 50% bond portfolio has seen losses in almost 1 of every 5 one-year periods and more than 1 of every 25 five-year periods over the past 73 years of available data.  Thus, it is clear that no single mix of investments is likely to meet all of the needs for a portfolio in every market environment.

The Need for Active Management of Risk

The analysis to this point has discussed the need to balance long-term growth and preservation of capital, and it has summarized the tradeoff between these conflicting goals.  There remains, however, an important issue regarding the appropriate stock exposure for you in the current environment.  Even though returns over the long-term may have been strong for an all-stock portfolio, your returns will be very much dependent on the market conditions at the start of the investment period.

To set up this discussion, consider the risk of failing to achieve a target return of 5%, 8% or 10% in the S&P 500 over the last 44 years.



   1 Year  3 Years  5 Years  10 Years
 % Periods with Less Than a 5% Return:   32%   15%   17%   13%
 % Periods with Less Than an 8% Return   38%   29%   27%   32%
 % Periods with Less Than a 10% Return   41%   41%   41%   44%


Taking the risk of failing to achieve your return goals one step further, does this risk increase with an expensive stock market?  Looking at several different stock valuation measures, the U.S. stock market is currently at historically extreme levels.  As an example, the S&P Industrials price-to-sales ratio was 2.0 at the end of 1998.  High valuation measures are often associated with periods of high volatility in stocks, and a price-to-sales ratio greater than 1.0 (i.e., ½ of current level) has historically been considered high.



   1 Year  3 Years  5 Years  10 Years
 % Periods with Less Than a 5% Return:   42%   26%   24%   45%
 % Periods with Less Than an 8% Return   47%   55%   55%   79%
 % Periods with Less Than a 10% Return   49%   71%   71%   97%


Understanding the Data

The data in the table above indicates that high market valuations significantly increase the risk of failing to achieve even moderate return goals.  In all, there were 50 quarters from 1955 to 1998 in which the S&P Industrials price-to-sales ratio was over the 1.0.  During these periods, strong returns were possible, but less likely to be sustained than when there are less optimistic valuations in the market.  While this does not mean that a major correction or bear market will necessarily occur, the risk of failing to meet your goals is clearly higher than average based upon this data.  Because the market is a discounting mechanism, the positive economic environment we see today may become over discounted, resulting in moderate returns until fundamentals catch up with the optimism.


Clearly, history tells us that no single mix of assets may provide both long-term capital growth and stability of market values in all market and economic conditions.  Far too often, investment professionals take a passive approach to asset allocation, relying on past average returns and correlations to determine asset allocation without a full understanding of the long periods of time in history over which there are significant deviations from long-term averages. This data confirms that a more active approach to asset allocation based on the risk faced in today’s market and economic environment is key to lowering the risk to your portfolio failing to meet its investment objectives.


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One Response

  1. Developing a Proper Asset Allocation Perspective

    It has been said that the most difficult single feat in professional sports is hitting a major league pitch that can arrive at the plate in as few as 0.4 seconds after being thrown. But, according to Wayne Firebaugh CPA, CFP™ CMP™ of this ME-P, perhaps the most difficult feat in investing is setting an asset allocation.

    For the endowment manager (and most other investors) maintaining proper perspective of risk and return is likely the most difficult aspect of setting investment policy. Although investing carries many risks, William Spitz, CFA, the treasurer of Vanderbilt University School of Medicine and manager of the team that provides day-to-day management of Vanderbilt’s $2.25 billion endowment succinctly summarized the risks that should represent the primary areas of concern:

    1) the endowment could suffer an unacceptable market loss;
    2) there could be a decrease in the amount of support the endowment could provide to the sponsoring institution; and
    3) the endowment could fail to preserve its real purchasing power.

    When balancing these divergent risks, the endowment manager must remember that an endowment is a matter of “inter-generational equity” meaning that the future generation cannot and must not be harmed by actions taken on behalf of the current generation. When establishing the allocation for an endowment, the concept of inter-generational equity means that the manager must take a long-term perspective. Such a strict long-term perspective would likely require an almost complete equity allocation. However, since most healthcare institutions have immediate needs, an endowment manager’s investment allocation must also remain sensitive to the needs for current period funding.

    To put endowment management into a more personal perspective, Firebaugh likens it to investing an individual retirement account (IRA) for a 65-year old Mr. Methuselah who is preparing for 904 golden years of retirement bliss. His dilemma involves satisfying a need for current income while ensuring that he preserves the purchasing power of his portfolio.

    What do you think?
    Dr. David E. Marcinko MBA, CMP™

    Financial Planning and Risk Management Handbooks for Doctors


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