bonds are safe they come with two promises: the income stream they provide is usually fixed and...

Bonds Are Safe

They come with two promises:

The income stream they provide is usually fixed and relatively certain.

They will not mature at less than par or “face value.”

Therefore they are not risky.

•

•

•

Stocks Are Risky

They fluctuate in value substantially.

It’s hard to predict what they will be worthat any point in time.

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•

2% 4%0% 6% 10% 12% 14% 16% 18%8%

0%

2%

4%

6%

8%

10%

12%

14%

Asset Allocation by Holding PeriodS&P/LT Bonds

Standard Deviation

Avera

ge A

nn

ual R

etu

rn 100% Eq/0% Bonds90% Eq/10% Bonds80% Eq/20% Bonds70% Eq/30% Bonds60% Eq/40% Bonds50% Eq/50% Bonds40% Eq/60% Bonds30% Eq/70% Bonds20% Eq/80% Bonds10% Eq/90% Bonds0% Eq/100% Bonds

Color Description

Greater Risk

Gre

ate

r R

etu

rn

2% 4%0% 6% 10% 12% 14% 16% 18%8%

0%

2%

4%

6%

8%

10%

12%

14%

Asset Allocation by Holding PeriodS&P/LT Bonds

Standard Deviation

Avera

ge A

nn

ual R

etu

rn

1 Year

100% Bonds

100% Equities

100% Eq/0% Bonds90% Eq/10% Bonds80% Eq/20% Bonds70% Eq/30% Bonds60% Eq/40% Bonds50% Eq/50% Bonds40% Eq/60% Bonds30% Eq/70% Bonds20% Eq/80% Bonds10% Eq/90% Bonds0% Eq/100% Bonds

Color Description

2% 4%0% 6% 10% 12% 14% 16% 18%8%

0%

2%

4%

6%

8%

10%

12%

14%

Asset Allocation by Holding PeriodS&P/LT Bonds

Standard Deviation

Avera

ge A

nn

ual R

etu

rn

3 Year1 Year

100% Bonds

100% Equities

100% Eq/0% Bonds90% Eq/10% Bonds80% Eq/20% Bonds70% Eq/30% Bonds60% Eq/40% Bonds50% Eq/50% Bonds40% Eq/60% Bonds30% Eq/70% Bonds20% Eq/80% Bonds10% Eq/90% Bonds0% Eq/100% Bonds

Color Description

2% 4%0% 6% 10% 12% 14% 16% 18%8%

0%

2%

4%

6%

8%

10%

12%

14%

Asset Allocation by Holding PeriodS&P/LT Bonds

Standard Deviation

Avera

ge A

nn

ual R

etu

rn

5 Year 3 Year1 Year

100% Bonds

100% Equities

100% Eq/0% Bonds90% Eq/10% Bonds80% Eq/20% Bonds70% Eq/30% Bonds60% Eq/40% Bonds50% Eq/50% Bonds40% Eq/60% Bonds30% Eq/70% Bonds20% Eq/80% Bonds10% Eq/90% Bonds0% Eq/100% Bonds

Color Description

2% 4%0% 6% 10% 12% 14% 16% 18%8%

0%

2%

4%

6%

8%

10%

12%

14%

Asset Allocation by Holding PeriodS&P/LT Bonds

Standard Deviation

Avera

ge A

nn

ual R

etu

rn

10 Year

X

X

X

X

X

X

X

X

X

X

5 Year 3 Year

X

1 Year

100% Bonds

100% Equities

100% Eq/0% Bonds90% Eq/10% Bonds80% Eq/20% Bonds70% Eq/30% Bonds60% Eq/40% Bonds50% Eq/50% Bonds40% Eq/60% Bonds30% Eq/70% Bonds20% Eq/80% Bonds10% Eq/90% Bonds0% Eq/100% Bonds

Color Description

2% 4%0% 6% 10% 12% 14% 16% 18%8%

0%

2%

4%

6%

8%

10%

12%

14%

Asset Allocation by Holding PeriodS&P/LT Bonds

Standard Deviation

Avera

ge A

nn

ual R

etu

rn

20 YearX

XX

XXXXX

XX

10 Year

X

X

X

X

X

X

X

X

X

X

5 Year 3 Year

X

X

1 Year

100% Bonds

100% Equities

100% Eq/0% Bonds90% Eq/10% Bonds80% Eq/20% Bonds70% Eq/30% Bonds60% Eq/40% Bonds50% Eq/50% Bonds40% Eq/60% Bonds30% Eq/70% Bonds20% Eq/80% Bonds10% Eq/90% Bonds0% Eq/100% Bonds

Color Description

The Longer You Hold an

Asset Class, the More

Likely You Are to Receive

the Expected Return.

2% 4%0% 6% 10% 12% 14% 16% 18%8%

0%

2%

4%

6%

8%

10%

12%

14%

Efficient Frontier—Combinations of S&P 500 withLong Term Government Bonds and with Treasury Bills

For 1-Year Holding Periods

Standard Deviation

Avera

ge A

nn

ual R

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S&P / T-Bills

S&P / LT Bonds

8.00%

9.50%

9.70%

9.90%

10.10%

10.30%

10.50%

10.70%

10.90%

11.10%

8.50% 9.00% 9.50% 10.00% 10.50% 11.00% 11.50% 12.00% 12.50%

Equal Risk/Return Portfolios for 1-Year Holding PeriodsTraditional 50/50 Stock & Bond Portfolios

Vs. Stock & Treasury Bill Portfolios

Standard Deviation

Avera

ge A

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ual R

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71% S&P, 29% T-Bills

57% S&P, 43% T-Bills 50% S&P, 50% LT Govt Bonds

1950-95

The Economics of Investing

The creation of a portfolio must be driven by the expectation of when the portfolio will be called upon to provide benefits (cash flow to meet specific needs).

A time line with quantifiable cash calls must be established before an optimal portfolio can be constructed. Out flows may be regular or irregular but they must be estimated.

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Guiding Principle: The longer you hold an asset class the more likely you are to receive the expected return associated with that asset class.

A portfolio will provide optimal results when asset characteristics are matched to the timing of expected cash outflows.

Risk is managed by choosing the number of years that the portfolio is protected against the need to sell an asset when it is down in value.

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Guiding Principle: The greater the proportion of the highest rate of return asset class that you can hold, the better your return is likely to be.

Risk-Free orVery Low Risk

Highest Rate of ReturnAsset Class (Highest Short-Term Risk)

IooOOoIooOOoIooOOoIooOOoIooOOoIooOOoIooOOoIooOOoIooOOoIooOOoIooOOoIooOOoIooOOoIooOOoIooOOoIooOOoIooOOoIooOOoIooOOoIooOOoI

Year 0 Year 20

Guiding Principle: Matching the investor’s tolerance for risk with the number of years for which little or no risk is taken, to meet expected cash flows, provides the investor with a rational asset allocation framework.

Asset Allocation is a Dynamic Process

Years in which the high rate of return assets equal or outperform the expected returns, cash outflows are replenished (and/or in periods of substantial excess returns, additional amounts may be harvested).

Years in which the high rate of return assets underperform their expected returns, cash outflows are not replenished automatically.

The result is that a portfolio is constructed so the probability of having to sell the more volatile, but high rate of return asset class is greatly reduced.

The decision to replenish or not to replenish the low risk portion of the portfolio is a dynamic process.

The process considers normalized return expectations for each asset class, and the probable forward rate of return for each class relative to the other.

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Time Line

Risk-Free or Low Risk High Rate of ReturnAsset Class

S&P 500 (price only) CHANNEL TRENDS

100

1000

10000

1985 1990 1995 2000 2005 2010YEAR

S&P 500 INDEX

S&P 500CLOSE

HISTORICLOWER

HISTORICUPPER

NEWLOWER

NEWUPPER

HISTORICMEDIAN

NEWMEDIAN ?

S&P 500 (Price Only) Channel Trends

S&

P 5

00 I

nd

ex

Bonds Are Safe

They come with two promises:

The income stream they provide is usually fixed and relatively certain. The promise is that the income stream will never increase.

They will not mature at less than par or “face value.” The promise is that they will never mature for more than par.

Therefore, bonds are not risky. The reverse is that the value of a bond at any time is impacted by the level of current interest rates and the length of time you have to wait until the bond matures. To know what a bond will be worth at any point in time (other than the day it matures) an interest rate forecast must be made. I know of nothing more difficult, and as likely to be wrong.

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Stocks Are Risky

Stocks fluctuate in value substantially. True, but this characteristic can be managed by proper portfolio management techniques.

It’s hard to predict what stocks will be worth at any point in time. However the stock market has a trend that is inextricably tied to the creation of wealth in this country. As a result, stock market value is likely to increase over time and the income stream has historically increased as companies secularly increase dividends from increased earnings.

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Unparalleled opportunity to manage tax consequences•

Qualified dividends

When to take preferential long-term capital gains

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Stocks Are Risky (cont.)

Cash Equivalents as Percent of Portfolios

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

800.00

900.00

1,000.00

1,100.00

1,200.00

1,300.00

1,400.00

1,500.00

1,600.00

Cash

S&P QuarterlyClose

Cash Equivalents as Percent of Portfolios

S&P 500 with Barra Growth and Value

-30.00

-20.00

-10.00

0.00

10.00

20.00

30.00

40.00

50.00

1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

S&P 500

S&P Growth

S&P Value

S&P 500 with Barra Growth and Value