PART I
THE FIVE ESSENTIALS
CHAPTER 1
The First Essential: Determine the Right Asset Allocation
Now letās turn to improving your investing skills.
Chapters 1 and 2 are the most important in this book. To give you an idea how important they are, over 2,500 books and countless magazine and newspaper articles have been written on the subject of how to spread your money amongāand withināclasses of assets.
Given its fundamental nature you would think that virtually every investor would be well acquainted with the principles of diversification. Yet I find that such is not the case. I continually run across investors who have only the haziest idea of how to correctly implement an asset allocation and diversification strategy. I use a quick test to gauge their competency in this area:
Question: Do you know what percentage of your portfolio is currently invested in equities? Yes, no, without looking it up? If you donāt carry that number in your head, you may not be applying whatever you do know correctly.
There is a tendency to ignore diversification, perhaps because it is so basic. And a fair number invest with the belief that they already know it all. But thatās not usually the case. So letās start at the beginning.
The Basics
Asset allocation basically means holding various asset classes whose performance is uncorrelated; that is, they fluctuate independently of each other. Thatās the whole point. If two investments fluctuate in tandem, they wonāt provide diversification, or reduce risk.
The three most important asset classes for individuals are: stocks, bonds, and cash. At the institutional level there are many more. For convenienceās sake, Iām going to call these classes of assets baskets.
The following statistical table shows that there is virtually no correlation among the three basic baskets. Zero is no correlation; 1.00 and ā1.00 are perfect positive and negative correlations. This is critical. You want zero correlation, or better yet, negative correlation. If two asset classes have a high positive correlation, then they are really variations of the same asset class, and donāt increase diversification.
Source: Capital Guardian, Sept. 17, 2010 presentation to Westchester Community College Finance Committee.
Asset Class | Correlation |
World equity vs. U.S. investment-grade bonds | 0.15 |
World equity vs. cash and cash equivalents* | ā0.02 |
U.S. investment-grade bonds vs. cash and cash equivalents | 0.03 |
Now you see why spreading your money among stocks, bonds, and cash gives you superior diversification and risk control. You are always at risk no matter what you do, but with this approach you have dramatically reduced the likelihood that all your investments decline at once. How you allocate these baskets in your portfolio can determine up to 90 percent of your returns. This alone tells you where you should be spending your investing time.
If you own your own business, though, diversification may not be an option. You will probably have all your money in it. But thatās not the case when you invest in other peopleās businessesāthatās what you do when you buy listed stocks. There you may have the choice of diversification or concentrated investing. Some people follow the concentrated path in investingāand some of these people become very, very wealthy. But in all likelihood, you will never know enough about the workings of publicly traded companies, or how the actions of other investors will impact your holdings to be comfortable putting all your money in one, or even a few, stocks. This also applies to investing in companies you work for, if they are large enough to have publicly traded stock. Let me be very specific: Diversification is not about maximizing profits; itās about reducing risk. And there is no better way to reduce risk. Itās not just for individuals, either. Many hedge fund and mutual fund pros have dispensed with diversification and come to grief because it is impossible to be expert in every holding. Expert or layman, when bad things happen there is really no protection other than diversification.
Diversification is not about maximizing profits; itās about reducing risk.
I think one of the reasons the Investor newsletter led the nation in risk-adjusted returns for so many years (we were number one among all newsletters for the 20 years ending June 2008) is because we had the best asset allocation. We were one of the few newsletters that routinely allocated part of our model portfolios to bonds. Most newsletter portfolios recommend stocks only, or even higher risk securities such as options.
Learn from the Big Boys
Even though you may never be an institutional player, itās useful to know what the big boys do. Hereās a comprehensive allocation developed by David Swensen, who manages Yaleās multibillion dollar endowment. He suggests six baskets with no asset class greater than 30 percent, or less than 5 percent:
1. Domestic stocks: | 30% |
2. Foreign stocks: | 15% |
3. Emerging-market stocks: | 5% |
4. Real estate: | 20% |
5. Treasury bonds: | 15% |
6. Treasury inflation-protected securities (TIPS): | 15% |
For individuals with substantial assets this allocation makes a great deal of sense.
Another asset class to consider is commodities, which are much simpler to invest in nowadays with the advent of sector exchange-traded funds (ETFs).
How the Ancients Allocated Their Wealth
Many contemporary investing strategies such as random walk, modern portfolio theory, index funds, and even growth stock investing were developed after World War II and are relatively new. But asset allocation is not new. Itās been around as long as people have had wealth.
The oldest recorded asset allocation advice may be from biblical times. The Talmud, a record of rabbinic discussions pertaining to Jewish law, ethics, customs, and history (circa 1200 B.C.āA.D. 500) recommends: āLet every man divide his money into three parts, and invest a third in land, a third in business, and let him keep a third in reserve.ā Today we would call these three baskets real estate, common stocks, and money funds. You can clearly prosper with that advice right now.
Jumping to more recent history, the fabled Rothschild family had an asset allocation formula that worked well for over a century and, amazingly, remains totally relevant today. The Rothschilds placed one-third of their wealth in each of three baskets: securities, real estate, and art.
Itās interesting that both historic examples allocated wealth into three baskets and thatās basically what most individuals do today, except that our baskets are slightly different. Today, we categorize the baskets as stocks, bonds, and cash, but the principle of three endures as a sound minimum.
And hereās another historic example of diversification. In Shakespeareās Merchant of Venice, Antonio declares, āMy ventures are not in one bottom trusted.ā
And, of course, thatās what insurance is all aboutāspreading the risk through diversification. Lloyds of London was founded around 1688 to insure shipping, so a shipper could put all his cargo in āone bottom.ā
Itās not known when American investors began to allocate their assets to both stocks and bonds, but the first balanced fund, Vanguard Wellington, was launched in 1929. Vanguard Wellington utilized a 60/40 distribution (stocks to bonds), which is still basic today.
Of course, we are more sophisticated now and at the institutional level, some large portfolios have as many as eleven baskets. Thatās too much for most individuals, but you can certainly consider commodities, timber, foreign bonds, inflation protected bonds, gold, real estate, art, collectibles such as fine wines, rare books, classic cars, jewelry, and memorabilia. Still, the ābig threeā are all you absolutely need.
Your Most Important Task: Determining the Best Asset Allocation for You
First of all, there is no single ārightā allocation. Itās essential to choose an allocation that works for you, considers your current holdings and, most importantly, takes into account a long-term market forecast and your personal risk profile, which depends on your financial ability to tolerate risk, and your willingness to do so.
Regardless of what you choose, the important thing is to know your target asset allocation and either stick reasonably close to it, or have logical reasons for not doing so.
There is no single ārightā allocation.
Here are some of the factors you need to consider to reach your own personal allocation:
- How many years before you need the money, either for retirement or for other purposes such as college?
- How long does the money have to last in retirement? An estimate is helpful.
- How easily can market losses be replaced?
- How much inflation protection do you need?
- Age: Generally older people should take less risk, but there are some significant exceptions. For most people age is closely linked to the time horizon.
These factors are really all facets of what is called your time horizon. For most people thatās the bottom line. In addition consider:
- Wealth (more important than most realize): Itās dangerous to take substantial equity risks if you donāt have a cushion.
- Family: How solid is your marriage? What child rearing expenses are you likely to incur (including college costs, and possible wedding expenses)?
- Are there any circumstances under which you would wind up being financially responsible for any other members of your family? Have you ever co-signed a loan?
- Income (if you are still working; or cash flow if you are not): How great is it? How stable is it? The more you have, the easier it is to accept risk.
- How much to set aside for emergencies?
- How much money do you want to set aside fo...