A random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing

FIVE ASSET-ALLOCATION
PRINCIPLES
Before we can determine a rational basis for making asset-
allocation decisions, certain principles must be kept firmly in
mind. We’ve covered some of them implicitly in earlier
chapters, but treating them explicitly here should prove very
helpful. The key principles are:
1. History shows that risk and return are related.
2. The risk of investing in common stocks and bonds
depends on the length of time the investments are
held. The longer an investor’s holding period, the
lower the likely variation in the asset’s return.
3. Dollar-cost averaging can be a useful, though
controversial, technique to reduce the risk of stock
and bond investment.
4. Rebalancing can reduce risk and, in some
circumstances, increase investment returns.

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5. You must distinguish between your attitude toward
and your capacity for risk. The risks you can afford
to take depend on your total financial situation,
including the types and sources of your income
exclusive of investment income.
1. Risk and Reward Are Related
Although you may be tired of hearing that investment
rewards can be increased only by the assumption of greater
risk, no lesson is more important in investment management.
This fundamental law of finance is supported by centuries of
historical data. The table below, summarizing the Ibbotson
data presented earlier, illustrates the point.
TOTAL ANNUAL RETURNS FOR BASIC ASSET
CLASSES, 1926–2009
Average
Annual
Return
Risk Index (Year-to-Year
Volatility of Returns)

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Small-company
common stocks
11.9%
32.8%
Large-company
common stocks
9.8
20.5
Long-term
government bonds
5.4
9.6
U.S. Treasury
bills
3.7
3.1
Common stocks have clearly provided very generous long-
run rates of return. It has been estimated that if George
Washington had put just one dollar aside from his first
presidential salary and invested it in common stocks, his heirs
would have been millionaires more than ten times over by
2010. Roger Ibbotson estimates that stocks have provided a
compounded rate of return of more than 8 percent per year
since 1790. (As the table above shows, returns have been
even more generous since 1926, when common stocks of large
companies earned almost 10 percent.) But this return came
only at substantial risk to investors. Total returns were
negative in about three years out of ten. So as you reach for

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higher returns, never forget the saying “There ain’t no such
thing as a free lunch.” Higher risk is the price one pays for
more generous returns.