Understanding
asset allocation is one of the most important aspects of investing.
Proper asset allocation provides the balance between risks and rewards
that are appropriate for you. Investments are categorized into
classes that have different risks and rewards.
Traditional asset allocation strategies
have investors take quizzes to determine their risk tolerance levels.
Then use that to allocate assets according to the investors risk
tolerance. There are three main categories in the traditional method:
stock, bonds, and cash More conservative investor are advised to invest
more in bonds and cash and less in stocks. While aggressive investors
are encouraged to invest everything in stocks. Once a strategy is
selected and assets are allocated the portfolio is rebalanced once a
year to maintain the allocation. If an asset class grows bigger than
its target allocation some of that class is sold and proceeds are used
to buy the other asset classes that dropped below the target allocation
to maintain the allocation. Younger people should be more aggressive
and as one gets closer to retirement assets should be allocated to less
risky asset classes. The traditional allocation misses some asset
classes like commodities and real estate.
Jim Rogers is critical of the traditional asset allocation. He is famous for being the co-founder of the Quantum Fund. The success of the Quantum Fund allowed him to “retire” at age 38 a multi millionaire. He says, “The way to get rich is to put your eggs in one basket,
but watch that basket very carefully.” He says that, “Diversification
is something that stock brokers came up with to protect themselves, so
they wouldn't get sued.” The Rogers’ strategy seems to be for experts.
For people that know the one thing they are investing in very well.
Harry Browne (a famous Libertarian) has a more conservative strategy. In 1999 he wrote a very good investing book titled “Fail-Safe Investing”. There is a new book The Permanent Portfolio based
on Harry Browne’s now classic book with updated information related to
changes with todays investing opportunities. I have not read this new
book yet. Harry Browne’s book describes a simple asset allocation
strategy. His suggested allocation is 25% in to each stocks, US
treasury bonds, gold, and cash. Browne does not consider real estate an
investment. He sees its value to dependent on the whims of government
bureaucrats and must be considered a speculation. Browns recommends
rebalancing once a year to maintain the allocation. This simple
strategy has proven successful with little work or skill needed to maintain it. There are even mutual funds that is based on it.
This is one of the simplest strategies for investing it requires little
analysis and maintenance. Just the initial plan for allocation and
rebalancing once per year.
It
is very important with this strategy not to get sucked into trying to
time the market. If you hold to it, and rebalance impartially this
strategy helps reduce the chance of losing money and allows your
portfolio to grow. During a bubble It is easy to get enticed into over
investing in assets that will collapse after the bubble. It can be hard
to watch everyone else making lots of money and not adjust your
allocation heavier into the booming asset. For example this strategy
did not grow as fast as tech stocks during the tech boom of the 1990s
but it also did not crash like the tech stocks did. So if you hold to
this strategy it provides a simple safe method for investing.
However
Harry Browne's original recommendation of US Treasury Bonds seems risky
with the looming sovereign debt crisis. Sovereign bonds probably have a
much greater risk now than any time previously. Harry Browne has
passed away and we can't get his opinion now. Craig Rowland the author
of the new book sticks with the US Treasury strategy. For those
concerned about government bonds there is a footnote in Harry Browne’s
book that recommends if you have moral objections to investing in
government bonds, to invest in AAA corporate bonds. I guess that would
reduce the risk from the high debt and obligations that the US
government has acquired in recent years.
Marc Faber a Swiss investor living in Thailand, best known for the Gloom Boom & Doom Report
newsletter, recommends various asset allocations as the market changes.
Yet they all seem very close to Harry Browne’s recommendations. At
the beginning of 2012 he recommended 25% in equities (stocks), 25% in
precious metals, 25% in cash and 25% in real estate. He has been
recommending avoiding sovereign bonds for a while and will often give
slightly different allocations in different interviews, he might
recommend asian real estate over other locations and so on. This
strategy is very similar to Harry Browns.
I
have tried to learn from each of these strategies and apply them to my
retirement investments. I categorize assets into five classes: stocks,
bonds, commodities, cash (also know as short term), and real estate.
There are sub classes within these classes, but I will not discuss
these in this article.
Stocks
tend to outperform all other asset classes in the long run, while they
are riskier in the short run. Bonds and cash are traditionally thought
of as less risky, though with the current sovereign debt crisis we
should consider government bonds and currencies both more risky than in
that past.
Each
asset class performs differently in different economic conditions.
During times of prosperity stocks perform well, interest rates fall
allowing bonds and real estate to perform well also. During price
inflation commodities, and stocks tend to perform better while bonds and
cash loses value. High interest rates that can accompany inflation can
hurt bonds and real estate. However if inflation gets too bad a rush
to hard assets could drive real estate up. In times of price deflation,
like depressions, cash is king, low interest rates allow bonds to
perform better, and dividend paying stocks give you valuable cash, while
prices of most things drop.
A the time of writing this, for my retirement account I follow the traditional allocation method but add in the commodity asset class from Browne and real estate asset class from Faber. I am more than 25s years away from when I expect to retire, so I try to be overweight in stocks (~65%). I like to emphasize dividend paying stocks. I try to stay away from long term government bonds, but hold some corporate bonds (~5%), a little cash in treasury backed money market funds (~5%). I also hold some real estate in a REIT based mutual fund (~5%), and some gold EFTs and mining stocks (~20%). As I get older I plan to move closer to a 20% allocation in the five asset classes by the time I retire.
I recommend The Voluntary Life podcast for for more information of investing:
Introduction to Investing
The Permanent Portfolio: Author Interview With Craig Rowland
How To Diversify Your Investments
A the time of writing this, for my retirement account I follow the traditional allocation method but add in the commodity asset class from Browne and real estate asset class from Faber. I am more than 25s years away from when I expect to retire, so I try to be overweight in stocks (~65%). I like to emphasize dividend paying stocks. I try to stay away from long term government bonds, but hold some corporate bonds (~5%), a little cash in treasury backed money market funds (~5%). I also hold some real estate in a REIT based mutual fund (~5%), and some gold EFTs and mining stocks (~20%). As I get older I plan to move closer to a 20% allocation in the five asset classes by the time I retire.
I recommend The Voluntary Life podcast for for more information of investing:
Introduction to Investing
The Permanent Portfolio: Author Interview With Craig Rowland
How To Diversify Your Investments
References:
Fail-Safe Investing by Harry Browne
The Truth About Money by Ric Edelman (chapter on hedging)
