Asset allocation is what the pie chart represents to most people with investments today. Over the past few decades, financial planners have trotted out pie charts that show the benefits of having assets in different asset categories. They espouse that being spread around limits risk. They also know that approach helps sell product.

The charts these financial salespeople show are usually loosely based upon an idea called Modern Portfolio Theory (MPT). The concept around MPT is that investors can use historical data to build safer portfolios. Certainly, when employed very well, there is some benefit to MPT as a way to use mean reversion as an investment tool. Unfortunately, in most cases, financial advisers do not use MPT properly to begin with due to a lack of training and relevant up-to-date data.

In addition, because MPT is focused on backwards looking data, it in no way takes into account changing secular conditions, such as, an aging population and aggregated global debt. Over the next 30 years, aging demographics and accumulated global debt will be two of the most important global trends that will have significant impacts on every aspect of the global economy and finance - and MPT has no way to incorporate that information.

Most financial people's idea of asset allocation therefore sticks with the notion that broad diversification equals safety. Nothing could be further from the truth. Consider 2008. With the exception of being short the markets or in U.S. Treasuries, everything dropped in price - a lot. Being diversified carried almost no benefit for investors. For many people, MPT was even worse as they hadn't properly accounted for mean reversion, thus, they not only lost on the crash, but they lost because much of their portfolios were "invested high" in various assets in the first place. 

Despite the failures of Modern Portfolio Theory, investors do need a model for asset allocation that we can build from. The chart above is based upon the ideas of Benjamin Graham - a key teacher and mentor of Warren Buffett - found in The Intelligent Investor (if you haven't read it, you need to read it). The core principle is that one-quarter of our money (excluding emergency and planned spending money in the bank, and primary residence) will virtually always be invested in fixed income and another one -quarter in equities. 

By investing one-quarter of our money in equities we are able to participate in the long-term growth of the stock market and provide a hedge against inflation. In general, I advocate focusing on energy, healthcare and technology investments which have been performance leaders over virtually every rolling long-term investment cycle. Using ETFs or mutual funds is a solid way to create that core portfolio for most people. 

With one-quarter of our money in fixed income we are able to add stability to our portfolio which generates ongoing dividends into the portfolio which can be used for other investing. To be sure, fixed income will never generate the returns of equities, however, for most people's risk appetite, the stability and cash flow generation is an important emotional anchor, even if it will never provide great investment returns. Consider however that Warren Buffett suggests we keep all of our invested money in equities.

With Buffett in mind, let's think about the flexibility that having fixed income in our portfolio's provides. Because we know that equities will suffer a significant correction periodically and then rebound substantially, having more stable fixed income in our portfolio gives us what Nassim Taleb (The Black Swan) calls "optionality" - in essence, the ability to strike when the iron is hot. So, when there is a rare opportunity, once or twice a decade, when we will want to shift much or all of our fixed income money into equities - after a major bear market correction of at least 20% in equities - because we have been holding fixed income, we will have the option to buy into that correction.

By making those infrequent, but efficient forays to being fully invested in equities, we give ourselves the occasional high probability opportunity to make high returns. The challenge to making this asset allocation shift is being emotionally in control, neither too scared, nor too anxious. It's not a small challenge. Once we are fully invested in equities, then we have to create a game plan for returning to having one-quarter of our money in fixed income. In general, we will want to begin selling into equity market strength as the equity market approaches the former highs of the market and complete the selling as the market either moves through the previous highs or retreats.

The circumstantial portion of our asset allocation represents half of our money. That is a lot. Here I strongly advocate individual equity securities - stocks and some options - if you can sleep at night with company specific risk. If you cannot sleep with company specific risk, then using ETFs is a wonderful approach as well - I still advocate using some options for risk mitigation and income generation. 

In general, we know that value investing works best long-term, unless you are a very good trader and can swing trade using quantitative or technical analysis. For most people, sticking with buying undervalued assets is the best approach as very few people - about 10% to 20% - can out trade the market. Right now, a significant portion of our "circumstantial" money is not invested, rather it is waiting in cash to be invested later as we wait for a value opportunity. Cash has been a good relative asset the past year. Cash is "optionality" too.

Today, there is very little value to be had in the markets. As I discussed in an article titled "Slow Growth Forever" we are seeing markets adjust for aging demographics and aggregated debt right now. That process will be slow and volatile as central banks continue to play with monetary policy. The stated goal of monetary policy is to create growth. As I'll discuss in an article soon, there is no way for central banks to stimulate growth beyond a certain point - a point we are roughly at. In the long-term, central banks will simply be devaluing debt. It will not be an even ride. We will soon see our 20% to 30% drop in equity prices to reflect the slower growth. When that happens, we will use our "optionality" to strike when the iron is hot.

Kirk


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