At Insightful Ideas, Inc., we have been helping people use technology to make their businesses more profitable for more than 20 years. While we have helped companies improve their bottom line through reducing costs or increasing revenues, our current focus is on dynamic asset allocation – using a service we call Dynamic Rebalancing. This is a refinement on the investment research and financial modeling we have been doing since 1996. Today the typical application of this financial modeling is the creation of Custom Target Date portfolios for corporate 401k plans.
To read more about how we used @Risk for Asset Allocation Modeling with institutional investment clients, check out our Case Study on the Palisade Web Site.
Our asset allocation models use investment asset class return assumptions with asymmetric (non-normal) probability distributions. Since the long-term expected return of equities is near 10% and the standard deviation is near +/- 16%, one might expect that 96% of the time returns should fall between -22% and + 42%. While the S&P 500 came close to the top of that range in 1997 it also fell to the low end in 2002. Interestingly the S&P 500 managed to come close to the top once again in 2013, while more importantly dropping significantly below the ‘expected’ low return in 2008. Our models, like the actual stock market, include a higher than 2% chance that the stock market could fall more than 2 standard deviations..
The goal of these simulation models is to seek an asset allocation which produces the highest total return with the lowest likelihood of producing a negative return by simulating uncertainty in the financial markets. Although this analysis is being used to show how pension plans and foundation endowments can better address their cash flow requirements by being invested in a diversified portfolio of stocks, bonds, and alternative investments, these lessons can also be used by individual investors. Our analysis shows us what could happen to an investment portfolio over a 5 year (or longer) time horizon in the greater than 1 in 50 chance that negative investment returns during some part of that 5 year period were worse than even the “Worst Case Scenario” of a typical analysis. What we find is an investment portfolio with an asset allocation properly balanced between stocks, bonds, and alternative investments should produce better risk adjusted returns than a more conservative approach or the typical 60% stocks and 40% bonds portfolio. Dynamic Rebalancing can improve the risk adjusted returns even more.
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