Part Three: Asset Allocation

The 5 Major Forces Affecting Your Investment Performance

by: Ben Crowley

1.Population

2.Supply and Demand

3.Asset Allocation

4.Relative Strength

5.Timing 

Part 3: Asset Allocation

U.S. Stocks, International Stocks, Fixed Income, Commodities, Cash and International Cash.  With the exception of alternative assets like art, collectibles and the like, these six asset classes are a general proxy for what you and I can easily build a portfolio around in a modern day brokerage account.  

(**Real Estate is a bit of a different beast because you can choose to invest in the actual property or buy shares of a real estate investment trust.  If you are dead set on owning property then fine, but for the sake of this discussion, I will consider real estate a sub category of the equities markets and can be owned in the form of REITs (real estate investment trusts).)

If you want to dig into the subject, David Darst is known as the ‘Godfather’ of Asset Allocation and has really done an excellent job of laying out the history, theory and mathematics behind this investment strategy over the years.  Be sure to check out “Mastering the Art of Asset Allocation” and for a little lighter read on the topic, “The Little Book that Saves Your Assets.”

If you, REALLY, want to get into the dirty details about correlation, non-correlation, modern portfolio theory or the really entertaining subject of statistical analysis, then you can call me and we can discuss it individually.  But, if you just want to get the gist of Asset Allocation, then just picture each asset class like you are visiting the primate section of the zoo.  

Fixed income is like the great Gorilla.  He is big, lazy and (at the zoo, at least) generally inactive, but you would not want to be in that cage when he is angry.  US Stocks, are like the chimpanzees.  Strong, intelligent, trainable, orderly and lovable.   Their behavior is generally predictable, but you can never fully trust them because you know in the back of your mind that they are wild animals, after all.  International Stocks, especially emerging markets, are like the Columbian Spider Monkey.  They are volatile, excitable, active during the day and tend to move in packs.   They are generally fun to watch but just when you fall in love with them, they get over-excited and throw their poop at you.      Commodities are like orangutans.  They are rare and wild and some are even endangered.  They are hard to find and sometimes you only get to see the ones that were bread in captivity.  And Cash, the most important of all.  Well, cash is the cage.  Cash is our defense against having these wild animals running all over the city.  No body ever looks at the cage.  It is not sexy or interesting.  But, when these animals get unruly and all act out at the same time, just thank your lucky stars that the cage is there to keep you safe.

In “normal” markets the order of things looks like this: Stocks are more volatile than bonds and typically have an ‘offense vs. defense‘ relationship.  Commodities move to their own beat and are often more directly tied to changes in supply and demand and the ‘economy’.  And cash is usually seen as a ‘safe haven’ when other asset classes are going down in value.  So, in theory, holding a certain percentage of each of these asset classes will smooth out your portfolio’s volatility and create a nice, even positive growth rate into perpetuity and you have portfolio Utopia.  Ahhhhhh... sounds nice doesn’t it? 

  

However, as with many theories, there is a fundamental flaw.  This method of portfolio management, does not take into account the disaster scenario that played out in 2008 and early 2009 where every monkey at the zoo was extremely pissed off all at the same time.  

In times like this, it is prudent to move all of your investments to cash and wait it out.  

Problem is, no professional fund manager in the world will ever, in their right minds, tell you that your money should be in 100% cash.  Why?  Because they don’t make any money that way.  They get paid to be invested and have assets under management.  If you sell your mutual funds and sit in cash, they have no money to manage.  I feel like this wrong on many levels and is one of the reasons I fell “out of love” with the financial services industry.  Throughout the whole time that the markets were plummeting, I never heard anyone who got paid to give advice ever say to move it all to cash and wait it out, or better yet.... “short the market.”  There is nothing wrong with shorting the market when it is appropriate and necessary but this is another topic all together.

My philosophy on asset allocation decisions in my portfolio management is a bit different.  In ‘Part 4, Relative Strength’ I will get into the methodology, but I believe that if you understand how asset classes behave and have a method of tracking their changing prices, you can make money in ANY market cycle.  At any given time, statistically, two of the six major asset classes are performing better than the other four.  On any given day, I own the two that are in the lead.    Sometimes that means being 100% invested in the stock markets and sometimes that means owning 100% cash. (if Cash is the best performing asset class then I am in cash completely.) Usually, however, the portfolio is somewhere in between.  

Since September of 2010, I have been 60% US and 30% Foreign Stocks and about 10% in gold and silver and am up handsomely.  Since the start of this blog in on January 24, 2010, my portfolio is up 3.3% and the S & P 500 is up 2.8%.  I am outpacing my benchmark by 40 basis points in three weeks and only time will tell how it does for the year.  However, I am less concerned with my performance in ‘good times’ because I know a rising tide raises all boats.  The strength of my strategy is in its ability to play aggressive defense when appropriate because we all know that offense scores points, but defense wins championships.  My goal in writing this blog is to teach you to win championships.  

Thus far, I have discussed Population, Supply and Demand and Asset Allocation.  If you can begin to apply this top down approach as a way to build and manage your own portfolio you too will derive the comfort and peace of mind that I have when I make investing decisions.  As always, I look forward to hearing from you and am happy to answer any specific questions.  

Happy Investing!