A case study in Asset Allocation EDITOR'S NOTE: This article was originally published in the July 2009 issue of Kiplinger's Retirement Report With the recession still going strong, now is a good time to reassess your portfolio. One decision to make: Should you choose an allocation that's heavier in bonds, or one that is weighted more toward stocks? Even a modest difference in allocation can affect your income stream and the growth of your portfolio over the long term. That is the conclusion Vanguard reached when it compared the 30-year performance of two of its popular balanced funds, one weighted more heavily toward bonds and the other toward stocks. Both funds are popular with retirees. But the bond-tilted fund produced higher initial income, while the investor in the stock-heavy fund enjoyed higher long-term capital appreciation. Vanguard studied the performance of its Wellesley Income Fund, which maintains an allocation of 60% to 65% bonds and 35% to 40% stocks. ItsIts Wellington Fund reverses the allocation, with 60% to 65% stocks and 35% to 40% bonds. Vanguard assumed that a hypothetical retiree invested $100,000 in Wellesley and another invested $100,000 in Wellington. The study assumed that the investors spent only dividend or interest income from their investments and not principal. All results were adjusted for inflation. Both investors retired at the end of 1978. Because of relative high interest rates, Wellesley's bond interest provided higher relative payouts in the early years than the Wellington's stock dividends. The Wellesley fund produced $7,839 in initial income, compared with $6,735 from the Wellington fund. Meanwhile, the stock-tilted Wellington fund produced significantly more capital appreciation over the years than the bond-heavy fund. Stocks generally provide higher rates of return over long periods than bonds. Wellington ended with a balance of $185,350 in 2008, compared with $84,330 for Wellesley. Your choice of an allocation depends partly on your goals and tolerance for risk. Income in the bond-heavy fund declined over time in part because of a drop in interest rates, says John Ameriks, head of the investment counseling and research department at Vanguard. Also, portfolios weighted in fixed-income investments often don't keep up with inflation. (The study was conducted by Vanguard analyst MariaIts Wellington Fund reverses the allocation, with 60% to 65% stocks and 35% to 40% bonds. Vanguard assumed that a hypothetical retiree invested $100,000 in Wellesley and another invested $100,000 in Wellington. The study assumed that the investors spent only dividend or interest income from their investments and not principal. All results were adjusted for inflation. Both investors retired at the end of 1978. Because of relative high interest rates, Wellesley's bond interest provided higher relative payouts in the early years than the Wellington's stock dividends. The Wellesley fund produced $7,839 in initial income, compared with $6,735 from the Wellington fund. Meanwhile, the stock-tilted Wellington fund produced significantly more capital appreciation over the years than the bond-heavy fund. Stocks generally provide higher rates of return over long periods than bonds. Wellington ended with a balance of $185,350 in 2008, compared with $84,330 for Wellesley. Your choice of an allocation depends partly on your goals and tolerance for risk. Income in the bond-heavy fund declined over time in part because of a drop in interest rates, says John Ameriks, head of the investment counseling and research department at Vanguard. Also, portfolios weighted in fixed-income investments often don't keep up with inflation. (The study was conducted by Vanguard analyst MariaIts Wellington Fund reverses the allocation, with 60% to 65% stocks and 35% to 40% bonds. Vanguard assumed that a hypothetical retiree invested $100,000 in Wellesley and another invested $100,000 in Wellington. The study assumed that the investors spent only dividend or interest income from their investments and not principal. All results were adjusted for inflation. Both investors retired at the end of 1978. Because of relative high interest rates, Wellesley's bond interest provided higher relative payouts in the early years than the Wellington's stock dividends. The Wellesley fund produced $7,839 in initial income, compared with $6,735 from the Wellington fund. Meanwhile, the stock-tilted Wellington fund produced significantly more capital appreciation over the years than the bond-heavy fund. Stocks generally provide higher rates of return over long periods than bonds. Wellington ended with a balance of $185,350 in 2008, compared with $84,330 for Wellesley. Your choice of an allocation depends partly on your goals and tolerance for risk. Income in the bond-heavy fund declined over time in part because of a drop in interest rates, says John Ameriks, head of the investment counseling and research department at Vanguard. Also, portfolios weighted in fixed-income investments often don't keep up with inflation. (The study was conducted by Vanguard analyst MariaIts Wellington Fund reverses the allocation, with 60% to 65% stocks and 35% to 40% bonds. Vanguard assumed that a hypothetical retiree invested $100,000 in Wellesley and another invested $100,000 in Wellington. The study assumed that the investors spent only dividend or interest income from their investments and not principal. All results were adjusted for inflation. Both investors retired at the end of 1978. Because of relative high interest rates, Wellesley's bond interest provided higher relative payouts in the early years than the Wellington's stock dividends. The Wellesley fund produced $7,839 in initial income, compared with $6,735 from the Wellington fund. Meanwhile, the stock-tilted Wellington fund produced significantly more capital appreciation over the years than the bond-heavy fund. Stocks generally provide higher rates of return over long periods than bonds. Wellington ended with a balance of $185,350 in 2008, compared with $84,330 for Wellesley. Your choice of an allocation depends partly on your goals and tolerance for risk. Income in the bond-heavy fund declined over time in part because of a drop in interest rates, says John Ameriks, head of the investment counseling and research department at Vanguard. Also, portfolios weighted in fixed-income investments often don't keep up with inflation. (The study was conducted by Vanguard analyst MariaBruno.) Ameriks says some retirees are willing to accept an income drop in their later years in return for a higher initial income. "They may feel they'll be more active and will spend more money in their early years of retirement," he says. "You have to be willing to live with less income as the years go on."Also, Ameriks says, many retirees cannot handle the volatility of a stock-heavy fund. In 2008, for instance, during the stock-market downturn, Wellington lost 22.3%, compared with a 9.8% drop for Wellesley. "Can you stomach big ups and downs? Are you comfortable with this level of volatility?" he says. Annual income for Wellington investors dropped during the recession of the early 1990s and the dot-com bust in 2001. For the investor in the stock-tilted portfolio, "you have to be willing to alter your spending when those dips occur," Ameriks says. Stock income declines when dividend-payout rates are lower. But a big reward from a stock-heavy portfolio is its potential for growth, which could benefit investors who want to leave money to their children or plan to spend more money later in life. Vanguard's analysis is another reminder that investors who are willing to handle the market gyrations of a stock-tilted portfolio will likely end up in a better place than those who place their bets with a bondweighted portfolio. Not only will investors with more stocks likely end up with a bigger balance over time, but there's a good chance that the returns on stocks could produce higher income. By 2000, the annual income in the stock fund for the 1978 investors surpassed that of the bond fund -- $7,878 in 1978 dollars for Wellington, compared with $5,215 in 1978 dollars for Wellesley.

1.1 Explain the term asset allocation and security selection. Use examples to distinguish the two. (4)

1.2 Allocation can affect your income stream and the growth of your portfolio over the long term. Using evidence from the case study advise the following clients on whether they should have a portfolio with more bond or stock weight. Give reasons for your answer. Also include other assets which may be appropriate in their portfolios.

a) Peter Jameson is risk averse works for Ethekwini Municipality he is in his mid 50s and is planning for retirement (2) b) Conol Stuwart is in his mid 20s just starting off his career and is a risk taker. He plans to spend more money later in life and leave money to his children. (2)

1.3 What are the reasons that people would invest in investments? (4) 1.4 Discuss the determinants of mutual fund performance (8)