Asset Allocation Basics

An Introduction to Diversifying Between Asset Classes

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In its simplest terms, asset allocation is the practice of dividing resources among different categories such as stocks , bonds, mutual funds, investment partnerships, real estate, cash equivalents and private equity. The theory is that the investor can lessen risk because each asset class has a different correlation to the others; when stocks rise, for example, bonds often fall. At a time when the stock market begins to fall, real estate may begin generating above average returns.

The amount of an investor’s total portfolio placed into each class is determined by an asset allocation model. These models are designed to reflect the personal goals and risk tolerance of the investor. Furthermore, individual asset classes can be sub-divided into sectors (for example, if the asset allocation model calls for 40% of the total portfolio to be invested in stocks, the portfolio manager may recommend different allocations within the field of stocks, such as recommending a certain percentage in large-cap, mid-cap, banking, manufacturing, etc.)

Asset Allocation Model Determined by Need

Although decades of history have conclusively proved it is more profitable to be an owner of corporate America (viz., stocks), rather than a lender to it (viz., bonds), there are times when equities are unattractive compared to other asset classes (think late-1999 when stock prices had risen so high the earnings yields were almost non-existent) or they do not fit with the particular goals or needs of the portfolio owner.

A widow, for example, with one million dollars to invest and no other source of income is going to want to place a significant portion of her wealth in fixed income obligations that will generate a steady source of retirement income for the remainder of her life. Her need is not necessarily to increase her net worth, but preserve what she has while living on the proceeds.

A young corporate employee just out of college, however, is going to be most interested in building wealth. He can afford to ignore market fluctuations because he doesn’t depend upon his investments to meet day to day living expenses. A portfolio heavily concentrated in stocks, under reasonable market conditions, is the best option for this type of investor.

Asset Allocation Models

Most asset allocation models fall somewhere between four objectives: preservation of capital, income, balanced, or growth.

Model 1 - Preservation of Capital
Asset allocation models designed for preservation of capital are largely for those who expect to use their cash within the next twelve months and do not wish to risk losing even a small percentage of principal value for the possibility of capital gains. Investors that plan on paying for college, purchasing a house or acquiring a business are examples of those that would seek this type of allocation model. Cash and cash equivalents such as money markets, treasuries and commercial paper often compose upwards of eighty percent of these portfolios.

The biggest danger is that the return earned may not keep pace with inflation, eroding purchasing power in real terms.

Model 2 – Income
Portfolios that are designed to generate income for their owners often consist of investment-grade, fixed income obligations of large, profitable corporations, real estate (most often in the form of Real Estate Investment Trusts, or REITs), treasury notes, and, to a lesser extent, shares of blue chip companies with long histories of continuous dividend payments. The typical income-oriented investor is one that is nearing retirement. Another example would be a young widow with small children receiving a lump-sum settlement from her husband’s life insurance policy and cannot risk losing the principal; although growth would be nice, the need for cash in hand for living expenses is of primary importance.

Model 3 – Balanced
Halfway between the income and growth asset allocation models is a compromise known as the balanced portfolio. For most people, the balanced portfolio is the best option not for financial reasons, but for emotional. Portfolios based on this model attempt to strike a compromise between long-term growth and current income. The ideal result is a mix of assets that generates cash as well as appreciates over time with smaller fluctuations in quoted principal value than the all-growth portfolio. Balanced portfolios tend to divide assets between medium-term investment-grade fixed income obligations and shares of common stocks in leading corporations, many of which may pay cash dividends. Real estate holdings via REITs are often a component as well. For the most part, a balanced portfolio is always vested (meaning very little is held in cash or cash equivalents unless the portfolio manager is absolutely convinced there are no attractive opportunities demonstrating an acceptable level of risk.)

Model 4 – Growth
The growth asset allocation model is designed for those that are just beginning their careers and are interested in building long-term wealth. The assets are not required to generate current income because the owner is actively employed, living off his or her salary for required expenses. Unlike an income portfolio, the investor is likely to increase his or her position each year by depositing additional funds. In bull markets, growth portfolios tend to significantly outperform their counterparts; in bear markets, they are the hardest hit. For the most part, up to one hundred percent of a growth modeled portfolio can be invested in common stocks, a substantial portion of which may not pay dividends and are relatively young. Portfolio managers often like to include an international equity component to expose the investor to economies other than the United States.

Changing with the Times

An investor that is actively engaged in an asset allocation strategy will find that his or her needs change as they move through the various stages of life. For that reason, some professional money managers recommend switching over a portion of your assets to a different model several years prior to major life changes. An investor that is ten years away from retirement, for example, would find himself moving 10% of his holding into an income-oriented allocation model each year. By the time he retires, the entire portfolio will reflect his new objectives.

The Rebalancing Controversy

One of the most popular practices on Wall Street is “rebalancing” a portfolio. Many times, this results because one particular asset class or investment has advanced substantially, coming to represent a significant portion of the investor’s wealth. In an effort to bring the portfolio back into balance with the original prescribed model, the portfolio manager will sell off a portion of the appreciated asset and reinvest the proceeds. Famed mutual fund manager Peter Lynch calls this practice, “cutting the flowers and watering the weeds.”

What is the average investor to do? On one hand, we have the advice given by one of the managing directors of Tweedy Browne to a client that held $30 million in Berkshire Hathaway stock many years ago. When asked if she should sell, his response was (paraphrased), “has there been a change in fundamentals that makes you believe the investment is less attractive?” She said no and kept the stock. Today, her position is worth several hundred millions of dollars. On the other hand, we have cases such as Worldcom and Enron where investors lost everything.

Perhaps the best advice is to only hold the position if you are capable of evaluating the business operationally, are convinced that the fundamentals are still attractive, believe the company has a significant competitive advantage, and you are comfortable with the increased dependence upon the performance of a single investment. If you are unable or unwilling to commit to the criteria, you may be better served by rebalancing.

Asset Allocation Alone Isn’t Enough

Many investors believe that by merely diversifying one’s assets to the prescribed allocation model is going to alleviate the need to exercise discretion in choosing individual issues. This is a dangerous fallacy. Investors that are not capable of evaluating a business quantitatively or qualitatively must make it absolutely clear to their portfolio manager that they are interested only in defensively selected investments, regardless of age or wealth level (for more information about the specific tests that should be applied to each potential security, read Seven Tests of Defensive Stock Selection.

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