Investing Basics: Asset Allocation For The Near Term

Investing Basics: Asset Allocation For The Near Term

Investing Basics: Asset Allocation For The Near Term by Anne Bucciarelli, Heather George, AllianceBernstein

Stocks tend to perform best over longer-term periods, but over shorter time periods, stock returns can be all over the map. Bond returns are usually lower but far more predictable. Since you can’t know for sure what will happen in the period ahead, the right asset allocation for you depends in large part on your time frame.

If you plan to use the money fairly soon (say, in less than two years) for something important (such as a down payment on a house or a wedding) it generally makes sense to keep most of that money in risk-mitigating assets such as cash instruments or fairly short-term bonds. For longer-term uses, such as education for your children or endowing your spending in retirement, a greater allocation to return-seeking assets such as stocks makes sense, as the Display below shows.

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Cash rarely loses value in nominal terms: Cash (represented by 3-month Treasury bills) has delivered negative returns in less than 1% of all three-month periods and no two-year periods since 1926. By contrast, stocks (represented by the S&P 500) have had negative returns in 37% of 3-month periods and 20% of two-year periods. Moving just 30% of an all-cash portfolio into stocks dramatically increased the share of periods with negative returns materially vs. the all-cash portfolio.

Cash is also highly liquid: There’s little chance that you won’t be able to withdraw your money when you want to, without accepting fire-sale prices or paying high transaction fees.

But holding cash has a cost. Cash returns have been lower than inflation over many three-year periods, as well as about one-third of all 10-year periods since 1926. Given the very low-interest-rate and low inflation environment today, we expect the return on cash after taxes and inflation to be negative over the next three years, as the next Display shows.

Asset Allocation

We expect the after-tax, inflation-adjusted return on bonds to be significantly better than cash over the next three years if market conditions are typical, represented by the diamond, or very good; we expect bond returns to lag cash only slightly if market conditions are very bad.

Even more remarkable, in today’s unusual market conditions, we estimate that returns for a conservative portfolio, with 30% in global stocks and 70% in bonds, would be no worse than cash if markets are hostile for the next three years—and would be much better if markets are typical or very good.

In sum, cash instruments are suitable if you need to put money aside for near-term needs, but when you’re investing for three years or more, holding cash is likely to mean forgoing significant gains.

The Bernstein Wealth Forecasting System uses a Monte Carlo model that simulates 10,000 plausible paths of return for each asset class and inflation and produces a probability distribution of outcomes. The model does not draw randomly from a set of historical returns to produce estimates for the future. Instead, the forecasts (1) are based on the building blocks of asset returns, such as inflation, yields, yield spreads, stock earnings and price multiples; (2) incorporate the linkages that exist among the returns of various asset classes; (3) take into account current market conditions at the beginning of the analysis; and (4) factor in a reasonable degree of randomness and unpredictability.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

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