Asset Allocation Models Explained
Here is a common definition of what asset allocation is considered these days: “Asset allocation refers to the investment strategy of balancing risk and reward by determining what percentage of your portfolio or net worth to put into various asset classes. Asset allocation basically means wealth diversification.”
We can continue with explaining: “The ideal goal with proper asset allocation is to maximize the risk-adjusted returns of a portfolio and tailor its growth potential and risks for an individual investor’s needs and goals.”
In theory, the asset allocation generates more performance than the individual selection of your securities within your stock portfolio. That makes much sense!
Consider this: You put 85% into bonds and 15% into stocks. With this combination, it almost doesn’t matter what you do in your stock portfolio (single stock selection) because the bond part dominates your wealth composition. Only in extreme leveraged cases could the equities part influence your entire wealth. Naturally, this daring behavior comes at a substantial risk to your stock portfolio and in worst-cases your entire wealth.
Another argument is, selecting individual stocks that massively outperform markets is very difficult while balancing your money between asset classes is simple and resembles portfolios of professionals.
The general rule to asset allocation management is, the more diversification the less the risk of course while at the same time getting exposure to any asset class that is hot. If Bitcoin is hot – no problem you just buy some cryptocurrencies, ICO coins or one of those fancy, new crypto ETFs.
If experts favor emerging markets, you can instantly get exposure in a very similar way.
The only problem with that approach is – you will almost certainly be behind the curve.
What does that mean for you and your wealth management? Let’s have a close look at the different components of Asset Allocation Models.
Personal Risk Factors
The standard textbook choices of mainstream asset classes are Cash, Stocks, Bonds and Real Estate. In recent years, commodities and alternative investments have been added to the standard allocation portfolio. However, thanks to the introduction of index funds and ETFs you can mirror any asset class imaginable, even the the most complex asset allocation models are in the reach of the common man & woman.
How you divide your personal wealth within these asset classes should be determined by your individual risk profile. Some standard determining factors would be your age, risk tolerance, and how hands-on they want to be with their investments, as described below. Other factors are the actual size of your wealth and the impact of fees on your performance. As mentioned before, ETF has greatly reduced the problem of fees depending on how liquid and how mainstream an asset class is. A standard stock market index benchmark ETF can be purchased and sold for less than 3 basis points.
Unfortunately, a considerable side effect of lower fees and more having more options, asset allocation management has become more complex and confusing. These days there are three times more ETF choices worldwide than there are actual stocks listed on stock exchanges. For example, the four largest asset classes could be broken down into further sub-categories. Domestic stocks could be split into large companies and small companies. Foreign stocks could be divided into developed and emerging markets. Bonds could be split into government bonds and corporate bonds.
Thanks to more options and choices within asset classes and providers the risk of seriously underperforming a standard stock index benchmark fund or just a normal three-pronged asset allocation model equally weighted has greatly increased.
Again, the risk of chasing hot trends and being behind the curve, as a result, is considerable. In other words, asset allocation management has become as complex and difficult as selecting a portfolio of 30 stocks or more.
Types of Asset Allocation
- Strategic Asset Allocation
- Tactical Asset Allocation
Strategic Asset Allocation means holding a passive diversified portfolio, and not changing your allocations based on market conditions. You just hold, add money, and re-balance. Tactical Asset Allocation is more advanced and refers to actively adjusting your weightings to different asset classes based on momentum or expected forward returns from those asset classes.
Tactical asset allocation is a more hands-on approach where you adjust your allocations to various asset classes based on where you think good risk/reward ratios exist in the market.
As an example, some investors (including Vanguard founder Jack Bogle) actively reduced their exposure to U.S. stocks during the height of the Dotcom Bubble because they saw how dramatically overvalued U.S. stocks were at that time compared to bonds. As a result, they minimized their exposure to the massive bear market in stocks that happened for years afterward.
The advantage is that you can substantially reduce your volatility and mildly increase your returns. However, it’s more prone to human error, and if done poorly will reduce your returns.
The Standard Approach
The generally recommended approach is more strategic in nature. It is recommended to follow a diversified buy-and-hold passive investing approach – with substantial exposure to stocks as a percentage of the asset pie. Within equities, it is then recommended to buy a wide range of stock funds divided into domestic and foreign stocks.
For this strategy, you build a diversified portfolio of index funds or ETFs, and re-balance from time to time. In other words, when one asset class goes up and another goes down, you sell some of the higher asset class and buy the dip in the underperforming asset class, to maintain the same weighting over time.
Supposedly it is an easy approach to building wealth for many people and limited risk.
The side effect of such an oversimplified approach, in my point of view naive approach, can be seen with GPIF’s asset allocation management. The entire fund is down 9% for just one quarter of 2018. The reason, they increased their stock exposure to the worst possible time with high exposure to hot tech related funds and stocks.
A classic case of being behind the curve- which should not have happened with risk tolerance and profile of a fund of such caliber. It’s pension money we are dealing with and the risk of being seriously underfunded for the demographic shift as serious as that of Japan.
Other argue, that due to the size of GPIF (largest pension fund of the world) they had no choice but follow such an approach. Well, then they shouldn’t have increased their exposure at the worst possible time – in a raging bull market.
The Disadvantages of the Mainstream Approach
In most cases, investors use both the strategic and tactical approach. Many times they have to admit that that not the differences between the two categories are the issue, but the timing and execution thereof. First, they to commit religiously to one or the other approach only to change their management at the worst possible time. Again, the GPIF, is an excellent example of such a worst-case scenario.
Another memorable example is when conservative investment management companies in Boston denounced all tech stocks in the late 90s only to change their minds in 2000 when they couldn’t resist any longer. At the very height of the tech bubble, they finally loaded up on tech stocks only to see their holdings drop a few months later.
In many cases, public pressure and pressure from the very top are the main culprits for such fatal asset allocation decisions. In the end, it doesn’t really matter whether it was considered a strategic or tactical decision – the losses are all that count.
The general idea that younger people have a higher propensity towards risk and hence should allocate a much higher portion towards equities is complete madness and utter nonsense! Blindly following a pie chart model can be the undoing for a young person’s path to wealth. First, they don’t learn anything except for transferring money and following the advice of financial advisors and bankers. Second, it can have fatal consequences, when they are entering the market at the worst moment of a bull market.
A loss is a loss for anyone regardless of their demographic bracket. Besides, it’s the person who executes such dumb strategies who realize real losses for bogus theory and oversimplified concepts.
80/20 Way to Asset Allocation
Diversification as a sole reason to be diversified is a bogus reason in investing and should never be followed without assessing your options first. A textbook asset allocation model requires you to pay high fees, with or without ETFs, with very little control over your decisions and the returns are usually lousy – thanks to excessive diversification. These days, return estimates for models similar to the image above are 5% or less for the next five to ten years – and that is before tax.
“Vanguard dramatically cuts its expected rate of return for the stock market over the next decade”
What I like to call “dumb diversification” or “dumb asset allocation” should never be an issue for 80/20 investors or smart investors for that matter. The asset allocation approach we follow is guided by the 80/20 Principle, an understanding of personal strength and the availability of opportunities at any given time.
The ideal 80/20 Investor is an entrepreneur or high-income employee with excess savings opportunities.
Thanks to the 80/20 principle to investing, we can manage asset allocation fairly easily and without the complexity and active work involved by mainstream financial advisors and private banks.
Asset Allocation – Wealth Creation
The results are focus, simplicity and liquidity advantages. In short, you will be able to operate from a position of financial strength rather than being guided by unnecessary and in most cases ineffective and expensive diversification.
For example:
Most of your investment exposure should be towards the one asset class that generates the strongest and most controllable cash flows. In many cases that is either your job or your own business interests. Within this single asset class, you can then diversify plenty. Here are some examples:
- different bank accounts
- different business lines/ product lines
- invest in further education and training
- diversify in different currencies
- and much more
Doing this will give you plenty of risk diversification, liquidity, and the highest possible risk-adjusted returns and tax optimization.
The reason for being the most optical risk-adjusted returns is simple. You are in control of the cash flows you own, fully understand and have absolute control over your liquidity management.
In many cases, it is already tax optimized as we seek tax advantages for our business management or personal income. For employees, there are fewer tax advantages but there are also benefits employees could make use of, such as educational benefits or matching contributions for savings plans by your employer.
So if you have an opportunity to plow back money in your own controllable cash flow asset class, consider your default asset class first and compare them with any other asset class that are at your disposal. Most of the time, you will realize the return opportunities far surpass and risk diversification considerations.
Advanced Selection
The advanced approach to asset allocation is based on liquidity management and the availability of opportunity. This requires more work and effort.
It requires to follow financial markets around the world and the elementary understanding of the main asset classes as an investor. The 80/20 Investors Premium Membership will help you with that – after all, this is the main purpose of this membership program.
In reality, this means, when an entire asset class becomes cheap, we research and make a judgment call to build exposure over time. This gives you plenty of time to do your homework while monitoring performance progress.
The default asset class is always a diversified cash portfolio in different currencies and a small percentage in physical gold (5 o 10%). Certainly, we encourage you to collect interest on your cash – as long as the money market products are insured and liquidi. Again we will make guiding recommendations.
The same approach applies to each asset class.
Our strength or marketable securities – foremost listed stocks. There is no better way to make use of opportunities than buying and selling stocks. Each day, someone makes terrible mistakes and we want to make use of these. We don’t chase hot trends! We either create them or we pick up the pieces of the hot trend terribly gone wrong.
For Real estate investors, this means, searching for outstanding opportunities and most of the time spending the time waiting and researching possible deals. The advantages are of course substantial financial leverage, cash flow management, and large exposure. The disadvantages are of course, liquidity constraints and substantial financial risk if leverage is done wrong due to the sheer size of this in many cases, dominant asset class.
We usually prefer marketable securities for real estate exposure, due to the liquidity and ease of use – but this is usually determined by each individual 80/20 Investor.
Asset Allocation – Wealth Protection
When it comes to wealth protection a complete different approach might be in order. Those of us that have already accumulated wealth through either diligent saving from the primary cash inflow.
Remember, this could either be through a well-paying job or your business interest.
Yet, it comes back to the question of what to do with all that money. Mind you, there are plenty of case where we have more money to go around than having a prudent asset allocation strategy to protect and maybe increase that wealth above inflation.
Well we don’t have to look far nor do we have to expect a very complicated formula or secret tip. In fact, this approach is truly worthy of 80/20 Investing.
In his book “The Road to Ruin” James Rickards tells us a fascinating story of meeting really “old money” during a gala dinner party. An Italian family dynasty, whose fortune can be traced back nine hundred years and who ultimately survived “the Black Death, the Thirty Years’ War, the wars of Louis XIV, the Napoleonic Wars, both world wars, the Holocaust, and the cold war.”
Here was a family that really understood to protect its family fortune and even grow it over time. Their rule was as simple as it makes sense for a family with that type of wealth: ” A third, a third, and a third. – You keep one third in land, one third in art, and one third in gold.”
The family member continues: “Of course, you might have a family business as well, and you need some cash for necessities. But land, art, and gold are the things that last.”
And you go, getting a wealth secret from a family that has endured more than 900 years and keep in mind. In Europe and Asia, there are plenty of family fortunes’ as prudently and simply managed as these.
It doesn’t need much explanation why these three types of asset classes should be included and why the 1/3 split diversification makes managing your existing wealth so easy. All three asset classes have been and will be discussed in more detail on this blog (so please subscribe below).
For now, we can see that following an 80/20 approach to wealth creation and wealth protection, your personal money management can be very much simplified – and may I even dare to say – and much more fun!
Conclusion
Having a balanced and yet thoughtful asset allocation approach for your personal portfolio is the key to investing success. However, the most important factor to remember is to focus on your strengths and willingness to get involved and ask questions.
This leads to the position of operating from a position of financial strength. Efficient diversification is always the prudent thing to do, but this can be done within your main default asset class.
If you possess a financial advantage in generating cash flows you don’t need to artificially diversify. You would only weaken your cash flow potential with sub-par returns from other asset classes. Only excess cash, cash you could not possibly redeploy into your existing business, should be strategically allocated to different asset classes for risk diversification purposes.
For that, we have a premium membership to determine your personal asset allocation models – the 80/20 way!
Read our newsletter and monitor our 80/20 asset allocation model and you will be able to outperform 80% or more of mainstream investors.
