Questions for Individual Asset Allocation Exercise:
1. Allocate your fictional $1,000,000 among the following three asset categories:
U.S. 30-Year Treasury Bonds
Justify your allocation based on your outlook for systematic risk in the U.S. economy over the next year.
Based on GDP, there is an expected growth in rates for the following quarter, though it may not be a dramatic one. Rates have been fluctuating within about a 1-2% range in the previous quarters following 2010. Investing in stocks would be logical when there is a growth since more business activities will be carried out, thus translating into higher corporate profits. However, a growing GDP may put the economy at risk of inflation.
GDP may be growing due to consumer confidence, which too seems to be steadily growing. Consumer confidence shows that consumers are more likely to spend and invest in the economy, which will help to boost it. This is good for stocks since a growing GDP will result in healthy corporate profits and
higher stock prices.
Consumers may be more able to spend and invest in the economy due to a fall in jobless claims. This means there are more people working so less people are filing for unemployment insurance, thus an improving labor market. Since more people have jobs there is more spending within the economy, which translates into a healthier economy overall. However, too little jobless claims may have a negative impact on the economy in that it may trigger wage inflation, which is bad news for the stock market. Businesses have to set out incentives like paying overtime or higher wages to attract employment, thus spending more in labor costs. The Federal Reserve tends to increase interest rates when wage inflation looks too threatening, which negatively affects both the stock and bond market.
Due to the aforementioned market risks in the economy, it seems optimal to invest the largest segment (45%) to US equities. The US seems to be thriving in a growing economy since the financial crisis, which is favorable to the stock market, since a healthy economy leads to an increase in equity prices, which thrives on growing corporate profits.
It would then be optimal to allocate 35% to US 30 year treasury bonds, since bonds tend to be less risky than stocks. Bonds have a higher likelihood of receiving a return on the investment than stocks, which have a higher possibility of loss. However, bonds do have a lesser return on investment, thus as much profit won’t be made compared to a stock that’s doing well. However bonds tend to be safer, though at the same time are at a risk of being affected by inflation since the economy often walks a fine line between strong growth and excessive growth in the economy.
Finally, 20% should be kept as cash just to make sure that there is cash at hand in case of emergencies. Since there are risks associated with both the bond and stock market alike, as the economy grows and becomes in risk of inflation. Cash will be able to provide flexibility during times when the market is feeling pressured.
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