Asset Allocation: What to Think About

Money-Guy 03-18-2011

Today, we are going back to the basics and talking about the importance of asset allocation. This podcast is meant to remind our devoted listeners, and reveal to any new listeners, some of the fundamentals of financial planning and how to best handle your assets.

Of course, I can’t bring up asset allocation without mentioning Modern Portfolio Theory. This theory attempts to maximize portfolio return, given a specified level of risk, by exercising proper diversification. While some criticize MPT (behavioral economists) for ignoring the fact that investors are irrational and markets are inefficient, I would argue that MPT actually does a pretty good job of leveling out both emotional and economic volatility.

In our view, asset allocation works. Despite popular opinion, it worked in 2008 (even though the outcome still didn’t feel great). My advice is to stay the course even during the hard times. Modern Portfolio Theory can help minimize the effects of uncertainty, and help you sleep better at night knowing that all your eggs aren’t in one basket.

I think it’s important to understand the basics of each asset class and how they can benefit your portfolio. As you listen, I cover each category from the most conservative to the most aggressive:

• Cash: Our thought right now is that cash is trash. However, it is still an asset class and we all need it in our portfolio in case of an emergency. One tip is to consider using an online savings account for cash reserves because they often offer better interest rates.

• Fixed-Income: When we’re talking about bonds, we have to focus on interest rates. Since the 1970s, we have lived in an environment of declining interest rates. Now, evidence is suggesting that just the opposite may occur in the future, which should change the way you invest in bonds. In a declining interest rate market, bonds go up in value.  If we move to a rising interest rate environment, bonds your currently own will go down in value. Another thing to consider looking forward is inflation-protected bonds.

• Hedged Equity (Long-short): Long-short funds are also known as hedge funds. These funds seek to mirror the market in good times and switch gears to make money even when the market goes down. If done right, they can serve as a sort of insurance policy to your portfolio. However, not all of these funds are created equally, so research thoroughly before making your decision.

• Balanced: These funds can be used to moderate the volatility of a portfolio. They are called balanced because they are made of part stocks and part bonds. The best advice I have for these funds is to know what you own. Know what percentage you have in stock and what percentage you have in bonds. Also know how much liberty your manager has to change those ratios later.

• Large Cap: When it comes to large-cap funds, we typically like using index funds because of their exceptionally low internal expenses. We vary from this a little bit, though. There are some valuable funds out there that allow you to avoid certain sectors and capitalize on certain strategies.

• Mid Cap/Small Cap: In these categories, we lean towards the value bias when choosing funds. Historical evidence shows that value has performed better in these asset classes than going the more aggressive, growth route. There has actually been a bias recently toward large-cap companies vs. small-cap companies because many believe large businesses can better capitalize off of global growth than smaller U.S. companies.

• International:  I think it is a no-brainer that you have to invest in international funds. We focus on emerging markets, while maintaining a healthy level of risk. But again, be aware that not all are created equal and do your research. Another tip is to avoid becoming too excited about global growth in a specific area and developing too much concentration.

• Real Estate: We’ve recently started easing back into real estate. One reminder for homeowners out there is that you already have a large exposure to real estate in your portfolio. Include all of your assets when you think about your total portfolio.

• Commodities: These include oil, natural gas, timber, precious metals, etc. Commodities will always be part of the discussion because of scarcity of resources. As economies develop, demand for commodities will increase. Keep in mind, too, that historically commodities serve as an inflation hedge.

To close out the show, I share some of my thoughts on public education and some possible reform that may be coming in the future.

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