Things to Consider When Balancing Your Asset Class Exposure
Success in asset allocation is about consistency, simplicity, and moderation
The topic of risk management, particularly balancing asset class exposure, has been on my mind lately. We think it's important for a lot of investors, and something that doesn't get enough attention in the financial press, where asset class recommendations tend to rise and fall with the same sense of cyclicality of Parisian fashions. I'm of the school of thought that it's much more basic; that there are certain timeless principles which, if honored, can help you build -- and keep -- wealth.
If you've been on the site for awhile, you have a head start because we've already discussed the importance of a discipline known as asset allocation, which involves selecting among different asset classes to build a well-balanced portfolio that can weather different economic environments, tax regimes, global conditions, inflation or deflation, and a host of other variables that history has shown will fluctuate over time. The key to successfully navigating the sometimes stormy waters that can make up your personal finances is that balance.
You want to be prepared for all seasons; to know that regardless of what happens with your employment situation, the government's budget, the Federal Reserve and interest rates, or the stock market, your family will enjoy higher income from dividends, interest, and rents with each passing year.
1. You Do Not Want All of Your Investment Capital Invested in Stocks
There is no doubt that, based on pure, cold, logical data, stocks are the single best long-term performing asset class for disciplined investors who are not swayed by emotion, focus on earnings and dividends, and never pay too much for a stock, often as measured on a conservative beginning earnings yield relative to the Treasury bond yield basis. It may not be glamorous, but Ibbotson & Associates data shows that those who were capable of doing this for long periods of time earned average rates of return of 10% per annum.
Those returns were incredibly volatile -- a stock might be down 30% one year and up 50% the next -- but the power of owning a well-diversified portfolio of incredible businesses that churn out real profit, firms such as Coca-Cola, Walt Disney, Procter & Gamble, and Johnson & Johnson, has rewarded owners far more lucratively than bonds, real estate, cash equivalents, certificates of deposit and money markets, gold and gold coins, silver, art, or most other asset classes.
It should be noted, for the record, that most people are not emotionally capable of doing this. One Morningstar study showed that during a period when the underlying portfolio assets were up 9% or 10%, the average investor earned 2% to 3% because of frequent trading, high expenses, and other stupid decisions. That is not a guarantee of failure because, if you aren't suited for the task, you don't have to invest in stocks to get rich.
With that said, stocks are unique because they are small pieces of ownership in businesses. These pieces of ownership, which we call "shares," are traded in a real-time auction that people refer to as the stock market. When the world falls off an economic cliff, many people and institutions who have mismanaged their liquidity find themselves in the unpleasant situation of having to sell off whatever they have sitting around to raise cash.
The result is that there is enormous pressure on stock prices, causing drastic declines in quoted market value. For the long-term investor, this is good, as it presents an opportunity to buy a larger equity stake, increasing ownership and, when times return to normal, profits and dividends. In the short-term, it can be devastating. When opportunities like this present themselves, you need a source of income outside of the stock market to generate cash for you to take advantage of the situation, as well as insulate you from the painful possibility of having to surrender your stock certificates at a fraction of their true worth just to pay the electric bill.
Whether this is a pile of corporate bonds, a highly profitable small business, real estate properties you own with little or no debt, such as apartment or office buildings, or intellectual property, such as copyrights and patents, is up to you to decide. The point is, you need something sending greenbacks your way when the equity markets fall apart from time to time -- which they will -- so you can take advantage of it.
2. You Probably Want Some Form of Conservatively Financed, Cash Generating Real Estate
Although the long-term returns on real estate are less than common stocks as a class (because an apartment building can't keep expanding), real estate can throw off large amounts of cash relative to your investment. The discipline of investing in this asset class requires some knowledge of specialization; e.g., rental houses have different economic characteristics and rents than industrial warehouses, storage units, office buildings, or lease-back transactions. You must also worry about things such as supply and demand projections for the local market, your liquid
ity situation, legal structure (you would never want to own a car wash directly in your name; instead, you'd want to hold it in something like a limited liability company), and insurance coverage. Still, in the end, having a tangible piece of property that you can see with your own eyes, touch with your own hands, and that allows you to physically watch cash come in regularly from the checks your tenants send you is powerful, both financially and psychologically.
The biggest danger of investing in the real estate asset class is the temptation to use too much leverage. Small down payments, rosy occupancy assumptions, and cheerful average rent projections have a habit of combining to form a trifecta of fiscal disaster for the unwary speculator who mistakenly believes he is acting like an investor.
3. You Should Not Underestimate the Importance of Cash and Cash Equivalents
In real, inflation-adjusted, after-tax returns, cash and cash equivalents are experiencing negative yields at the time this article was written. That means you are all but assured that you will lose purchasing power the longer you hold onto them. Still, cash can serve as a powerful anchor on your portfolio. In good times, it mitigates returns to a somewhat lower figure. In bad times, it helps stabilize a declining balance sheet. Some of the best and most experienced investors in the world have a habit of routinely keeping 20% of their net assets in cash and cash equivalents, often the only truly safe place for parking these funds being a United States Treasury bond of short-duration held directly with the U.S. Treasury.
Don't be one of those people that can't hold on to cash either because you spend it or are tempted to over-invest too quickly. Be patient. Liquidity management is one of the simplest, and most difficult, things to master. It requires an understanding and acceptance that the role of the funds in the cash and cash equivalent asset class are not meant to make money for you, but to serve as a margin of safety.
The Point of Balancing Asset Class Exposure Is Protection and Opportunity
Getting the asset class exposure right is one of the most important jobs you will have as the CEO of your life. It can put you in a position where you sail through economic maelstroms unscathed, losing no sleep. It can provide you with streams and sources of funds to deploy when opportunities present themselves as others scramble to pay their bills. Don't treat it like a small thing. Think long and hard about it. Beyond that, make sure you understand what you own.
Don't start adding asset classes that are beyond your expertise, turning down good opportunities in front of you out of some misguided sense of diversification. Yes, diversification is important but risk management must begin by making sure each and every position you hold, or in some cases, certain baskets of positions where you are making bets on entire sectors or industries, promises a satisfactory probability of good results even if things don't go well.