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The Big Picture - Asset Allocation
We spend a lot of time on individual investment ideas, but relatively little on how it all fits together. Yet studies show that the single biggest determinant of your investment returns over time is how you allocate assets among the major asset classes. So let's dedicate a thread to that all-important yet under-appreciated issue.
First, what are those major asset classes? For some they are stocks, bonds and cash. Some broaden the field to include commodities and real estate. A drawback of the first categorization is the problem of inflation. During periods of rising inflation, which many here expect, financial assets such as stocks bonds and cash can fail to keep up. In the 1970's for example, bonds and cash lost value to inflation, and even as the growth of corporate earnings under-girded stocks, their prices relative to those earnings contracted as the time value of money shrank with rising interest rates. The result was that a portfolio of stocks, bonds and cash lost value on all three fronts.
The inclusion of so-called alternative asset classes therefore seems to make sense. With that in mind, let's look at an asset allocation template. This is a general guide, not a one-size fits all model, but it gives us a framework within which to examine the issue. This model would be most appropriate for an American with no debt and no fixed-income proxies such as pensions (a pension, for example, would make up part of the fixed income allocation so the present value of a pension could in principle be subtracted from the fixed income portion of ones portfolio). It also assumes one has no particular outlook on the markets. If one was convinced that gold, for example, would outperform stocks on a long term basis, he could use a higher allocation of gold and a lesser allocation to stocks.
With that in mind, a basic portfolio model could include:
25% Cash & bonds - this would include bank savings, cash balances with your broker, and any funds that are invested in bills, notes or bonds such as SHY or TLT
25% Commodities - this would include your gold, silver, platinum, and copper bullion, and your net collateralized long position in commodity futures - for example shares in PCDRX.
50% Equities - this would include stocks, real estate and energy trusts, as well as funds that are invested in these securities.
The principle here is that each of these classes of assets tends to perform independently of the others. Some types of investments you may want to consider hybrids. For example, high yield Canadian energy trusts, aside from being fundamentally equities, also have a degree of bond-like character due to their yields and tend to be more interest rate sensitive than other equities. Similar remarks apply to real estate investment trusts. At the same time, however, they also have a commodity-like character due to their underlying hard assets. So you could classify these investments perhaps at 50% equity and 25% each bond and commodity. Just be sure that the majority of your bond and commodity allocations in a case like this are true positions in bonds, bullion, or futures.
Next, season to taste. Are you a more income-oriented investor? If so, you could emphasize bonds a bit more. Use an equity income fund for a portion of your stock allocation. Concentrate more on energy and realty trusts. Are you looking for capital appreciation? Do just the opposite. What about your investment outlook? Does gold figure very prominently in your investment outlook and goals? Increase the bullion allocation.
Regardless, it is very well advised to sit down and work out a long term asset allocation plan. One that reflects both your individual circumstances and your long term financial outlook, and that is adequately diversified among the major asset classes. Once you do that, review your portfolio a minimum of once every two years. If any class has significantly deviated from your target percentage, rebalance. In the mean time, if you like to take a more active role in managing your investments, you can review more frequently, perhaps in response to market swings. In any case, however, keep your basic asset allocation in mind, and if you deviate from it, be sure you have a reason you can articulate to yourself.
The basic concept here is a takeoff on the "Permanent Portfolio" as set forth in Harry Browne’s excellent book, Fail Safe Investing. In it Browne advocates an all-season asset allocation of 25% cash, 25% bonds, 25% stocks, and 25% gold, along with a rebalancing algorithm. Rather than attempt to lay out the case for his model, I recommend reading the book. It is a short book, easy to read, and elegantly simple in concept and application. Harry Browne, by the way, also wrote the book How You Can Profit In A Monetary Crisis over 25 years earlier, which despite its title is one of the best economics texts ever written and which formed the basis of my conception of finance and economics as a teenager. Browne, who just passed away a few months ago, was a master investor and also was twice the Libertarian Party nominee for President of the United States. He is also well known for his book How I Found Freedom In An Unfree World.
Financial Relativity
Finally, assess the value of each asset using some independent unit. Cash is just like any other security, but we - by the force of deeply ingrained habit due to its widespread use as our unit of account - tacitly assume it to be fixed in value. It most certainly is not!
This error is tantamount to taking any of the other components as constant; for example, assuming that the S&P 500 is fixed. If you were to then use that as the unit of measure for your portfolio performance you would see cash rising dramatically in value during the time period in question. But as Einstein might say, it’s all relative. Your error is very common - practically universal - due simply to the fact that we use our currency, the US dollar, as our unit of account. But aside from sheer force of habit, I would challenge you to defend your tacit assumption. Just try and justify a position that the value of the US dollar never changes!
On what grounds, for example, might you assert that in fact the real value of cash did not change and that it remained fixed as in stone as the stock market declined, rather than rising as the stock market remained fixed as in stone?
The real truth is neither.
But this is not merely an academic point. In fact, in the 1929-1932 experience, a great deal of the apparent losses in the stock market were in fact a phenomenon of a rising value of dollars. That’s why we call it a deflation. Not only did cash rise against stocks, but it also rose against real estate, commodities, groceries, and just about everything else. If you held a portfolio of 50% stocks and 50% cash, and the stock portion declined by 90%, most people would conclude that your overall loss was 45%. I strenuously object, however, countering that your cash gained in value - you just failed to acknowledge that fact by assuming cash to be constant and using the cash as your unit of measure.
It happened again in 2000-2002. Of course this time the Federal Reserve intervened with a massive, historic, inflationary effort before the slow-to-respond consumer prices went deep into the negative. We did briefly dip into CPI deflation in during that period, but the underlying deflation was cut short before it could really affect consumer prices to an extent resembling 1929-1932. Nevertheless, the assumption of constant cash value is unjustified.
This is a crucial point behind my FDI work. In fact, the main application I use it for is as the unit of account for my own portfolio performance. If the value of cash rises, I see it happening in my spreadsheets. If it falls (the more normal circumstance!) I see it declining. And if stock prices are merely reflecting inflation, the declining value of the dollar, then I am not lulled into thinking I am turning a real profit when in fact I’m just treading water. If you were to do the same with the portfolio I cited - and include dividends and interest, the effects of rebalancing, etceteras, you would find that even in this historical outlier of a financial environment, you would have done far better than the vast majority of investors and then gone on to do so in the subsequent environment as well.
Sometimes everything seems to be going down. Stocks, bonds, gold, what-have-you. These periods are relatively rare, but even then are mostly illusory. In fact, if that appears to be the case, one has to consider the possibility that maybe everything is not really going down, but that the unit in which we measure those things itself is going up. When you examine the historical record, and evaluate the performance of a portfolio such Browne’s in real terms, you simply do not find any protracted period where such a thing happens. Something is always going up. It’s just that when it happens to be cash, your use of cash as a unit of account leads you to fail to notice. Conversely, if everything seems to be going up, perhaps it is our unit that is shrinking.
Imagine a little "thought experiment". When I bought my last house, I measured it using a cotton ruler. Before I sold it, I washed the ruler and dried it at high heat. To my delight, my house had increased in square footage by over 60%! Encouraged by this revelation, I set my asking price at more than 60% over what I had paid … and got it!
Boy was that a good investment or what! How much richer I am now!
Alas, my logic founders on my failure to acknowledge the possibility that somebody did very much the same thing to the dollar during that period as I did to my cotton ruler.
We spend a lot of time on individual investment ideas, but relatively little on how it all fits together. Yet studies show that the single biggest determinant of your investment returns over time is how you allocate assets among the major asset classes. So let's dedicate a thread to that all-important yet under-appreciated issue.
First, what are those major asset classes? For some they are stocks, bonds and cash. Some broaden the field to include commodities and real estate. A drawback of the first categorization is the problem of inflation. During periods of rising inflation, which many here expect, financial assets such as stocks bonds and cash can fail to keep up. In the 1970's for example, bonds and cash lost value to inflation, and even as the growth of corporate earnings under-girded stocks, their prices relative to those earnings contracted as the time value of money shrank with rising interest rates. The result was that a portfolio of stocks, bonds and cash lost value on all three fronts.
The inclusion of so-called alternative asset classes therefore seems to make sense. With that in mind, let's look at an asset allocation template. This is a general guide, not a one-size fits all model, but it gives us a framework within which to examine the issue. This model would be most appropriate for an American with no debt and no fixed-income proxies such as pensions (a pension, for example, would make up part of the fixed income allocation so the present value of a pension could in principle be subtracted from the fixed income portion of ones portfolio). It also assumes one has no particular outlook on the markets. If one was convinced that gold, for example, would outperform stocks on a long term basis, he could use a higher allocation of gold and a lesser allocation to stocks.
With that in mind, a basic portfolio model could include:
25% Cash & bonds - this would include bank savings, cash balances with your broker, and any funds that are invested in bills, notes or bonds such as SHY or TLT
25% Commodities - this would include your gold, silver, platinum, and copper bullion, and your net collateralized long position in commodity futures - for example shares in PCDRX.
50% Equities - this would include stocks, real estate and energy trusts, as well as funds that are invested in these securities.
The principle here is that each of these classes of assets tends to perform independently of the others. Some types of investments you may want to consider hybrids. For example, high yield Canadian energy trusts, aside from being fundamentally equities, also have a degree of bond-like character due to their yields and tend to be more interest rate sensitive than other equities. Similar remarks apply to real estate investment trusts. At the same time, however, they also have a commodity-like character due to their underlying hard assets. So you could classify these investments perhaps at 50% equity and 25% each bond and commodity. Just be sure that the majority of your bond and commodity allocations in a case like this are true positions in bonds, bullion, or futures.
Next, season to taste. Are you a more income-oriented investor? If so, you could emphasize bonds a bit more. Use an equity income fund for a portion of your stock allocation. Concentrate more on energy and realty trusts. Are you looking for capital appreciation? Do just the opposite. What about your investment outlook? Does gold figure very prominently in your investment outlook and goals? Increase the bullion allocation.
Regardless, it is very well advised to sit down and work out a long term asset allocation plan. One that reflects both your individual circumstances and your long term financial outlook, and that is adequately diversified among the major asset classes. Once you do that, review your portfolio a minimum of once every two years. If any class has significantly deviated from your target percentage, rebalance. In the mean time, if you like to take a more active role in managing your investments, you can review more frequently, perhaps in response to market swings. In any case, however, keep your basic asset allocation in mind, and if you deviate from it, be sure you have a reason you can articulate to yourself.
The basic concept here is a takeoff on the "Permanent Portfolio" as set forth in Harry Browne’s excellent book, Fail Safe Investing. In it Browne advocates an all-season asset allocation of 25% cash, 25% bonds, 25% stocks, and 25% gold, along with a rebalancing algorithm. Rather than attempt to lay out the case for his model, I recommend reading the book. It is a short book, easy to read, and elegantly simple in concept and application. Harry Browne, by the way, also wrote the book How You Can Profit In A Monetary Crisis over 25 years earlier, which despite its title is one of the best economics texts ever written and which formed the basis of my conception of finance and economics as a teenager. Browne, who just passed away a few months ago, was a master investor and also was twice the Libertarian Party nominee for President of the United States. He is also well known for his book How I Found Freedom In An Unfree World.
Financial Relativity
Finally, assess the value of each asset using some independent unit. Cash is just like any other security, but we - by the force of deeply ingrained habit due to its widespread use as our unit of account - tacitly assume it to be fixed in value. It most certainly is not!
This error is tantamount to taking any of the other components as constant; for example, assuming that the S&P 500 is fixed. If you were to then use that as the unit of measure for your portfolio performance you would see cash rising dramatically in value during the time period in question. But as Einstein might say, it’s all relative. Your error is very common - practically universal - due simply to the fact that we use our currency, the US dollar, as our unit of account. But aside from sheer force of habit, I would challenge you to defend your tacit assumption. Just try and justify a position that the value of the US dollar never changes!
On what grounds, for example, might you assert that in fact the real value of cash did not change and that it remained fixed as in stone as the stock market declined, rather than rising as the stock market remained fixed as in stone?
The real truth is neither.
But this is not merely an academic point. In fact, in the 1929-1932 experience, a great deal of the apparent losses in the stock market were in fact a phenomenon of a rising value of dollars. That’s why we call it a deflation. Not only did cash rise against stocks, but it also rose against real estate, commodities, groceries, and just about everything else. If you held a portfolio of 50% stocks and 50% cash, and the stock portion declined by 90%, most people would conclude that your overall loss was 45%. I strenuously object, however, countering that your cash gained in value - you just failed to acknowledge that fact by assuming cash to be constant and using the cash as your unit of measure.
It happened again in 2000-2002. Of course this time the Federal Reserve intervened with a massive, historic, inflationary effort before the slow-to-respond consumer prices went deep into the negative. We did briefly dip into CPI deflation in during that period, but the underlying deflation was cut short before it could really affect consumer prices to an extent resembling 1929-1932. Nevertheless, the assumption of constant cash value is unjustified.
This is a crucial point behind my FDI work. In fact, the main application I use it for is as the unit of account for my own portfolio performance. If the value of cash rises, I see it happening in my spreadsheets. If it falls (the more normal circumstance!) I see it declining. And if stock prices are merely reflecting inflation, the declining value of the dollar, then I am not lulled into thinking I am turning a real profit when in fact I’m just treading water. If you were to do the same with the portfolio I cited - and include dividends and interest, the effects of rebalancing, etceteras, you would find that even in this historical outlier of a financial environment, you would have done far better than the vast majority of investors and then gone on to do so in the subsequent environment as well.
Sometimes everything seems to be going down. Stocks, bonds, gold, what-have-you. These periods are relatively rare, but even then are mostly illusory. In fact, if that appears to be the case, one has to consider the possibility that maybe everything is not really going down, but that the unit in which we measure those things itself is going up. When you examine the historical record, and evaluate the performance of a portfolio such Browne’s in real terms, you simply do not find any protracted period where such a thing happens. Something is always going up. It’s just that when it happens to be cash, your use of cash as a unit of account leads you to fail to notice. Conversely, if everything seems to be going up, perhaps it is our unit that is shrinking.
Imagine a little "thought experiment". When I bought my last house, I measured it using a cotton ruler. Before I sold it, I washed the ruler and dried it at high heat. To my delight, my house had increased in square footage by over 60%! Encouraged by this revelation, I set my asking price at more than 60% over what I had paid … and got it!
Boy was that a good investment or what! How much richer I am now!
Alas, my logic founders on my failure to acknowledge the possibility that somebody did very much the same thing to the dollar during that period as I did to my cotton ruler.
Of course, I am joshing, sort of. 
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