Dividend Value Builder Newsletter
Asset Allocation Categories & Guidance
Asset Allocation is where investors make their biggest investing mistakes. How you choose to divide your portfolio on a percentage basis is crucial to determining returns and portfolio risk.
What is Asset Allocation?
Asset Allocation is dividing an investment portfolio on a percentage basis among different asset categories. The concept of asset allocation is to combine investments whose asset correlation is low or negative. The idea is that when some asset categories are decreasing, others will be increasing.
By combining different assets with low or negative correlations, the volatility of the portfolio as a whole is lowered. Proper asset allocation can lower risk and increase returns at the same time. This makes asset allocation the highest priority in portfolio risk management.
Why Divide Your Assets?
“A diversified portfolio of investments, each of which is unlikely to produce significant loss, is a good start toward investment success.” Howard Marks
“Divide your portion to seven, or even eight, for you do not know what misfortune may occur on earth”. Ecclesiastes 11:2
One of the best approaches to lowering risk is to own a variety of assets. In other words, divide your assets among different asset categories. Owning a variety of assets, especially non-correlated assets, lowers portfolio volatility . This is why asset allocation is so important.
When one or two asset categories are performing poorly, you may have one or two that are doing well. The idea is to have a portfolio of assets that minimize risk and maximize opportunities for positive returns.
You know the saying “There is no free ride”? There are exceptions. Proper asset allocation and diversification provide benefits that can be harvested with little or no cost.
Many investors spend considerable time picking individual stocks but put little or no effort into thinking about how each holding affects the portfolio as a whole. Each individual investment should play a complementary role in the total portfolio.
Additional Reading: Investment Diversification Definition & Purpose
“Understanding and anticipating the power of correlation — and thus the limitations of diversification — is a principal aspect of risk control and portfolio management.” Howard Marks
There are an unlimited number of different approaches to asset allocation. In the interest of simplicity I’m going to divide a global investment universe into 7 asset categories. Each of these categories would have sub-categories.
Fixed income examples include Certificates of Deposit (CD’s), U.S. Treasury Bonds, Notes, and Bills; Treasury Inflation Protected Securities (TIPS), Corporate Bonds, and Foreign Bonds. Historically Bonds have had a low correlation with other major asset categories.
Domestic Stocks (Large, Mid-Cap, Small-Cap, and Micro-Cap)
Owning U.S. Stocks is an important asset category for obvious reasons. However, many U.S. residents have too large an allocation. If you aren’t invested in other asset categories (i.e. international stocks) you are missing out on opportunities and not taking advantage of the “free ride” diversification provides.
Foreign Developed Markets Stocks
The value of including foreign stocks is a greater universe of choices and increased diversification. Other regions and countries have different cycles. Their unique problems and opportunities create a wider variety of choices.
Emerging & Frontier Markets
The last couple of decades emerging and frontier economies have gravitated towards free market economics. In general, this has tilted investment capital toward these markets; increasing both the opportunities and their volatility. This is the perfect asset category for ETFs.
Commodities & Precious Metals
Commodities & Precious Metals have the advantage of low and sometimes even negative correlations with other investments. They also can be very volatile, providing opportunities and risks.
Depending on the size of your portfolio, many investors who own real estate directly, including your home, may want to ignore this in their investment securities portfolio. The concept of owning different assets is diversification; and for many investors the real estate they own would be more than sufficient diversification. If not, Real Estate Investment Trusts (REITS) and ETFs are readily available.
Cash and Cash Equivalents
Cash provides an asset category with a zero correlation to most assets and provides preservation of capital in bear markets. The zero correlation makes cash an important asset allocation category even during periods of low interest rates. In fact, it may be the most underrated and beneficial asset category in the current environment.
Asset Allocation Guidance
The importance of asset allocation can’t be ignored. Obviously there is not just one correct approach. Your asset allocation model might be very different from my example.
The goal is to implement asset allocation strategies that lower your overall portfolio volatility. While it may be more fun to pick individual investments, your asset allocation decisions will have the largest effect on your long term returns.
I have 5 pieces of guidance for your asset allocation:
1. Have Patience and a Long Term Horizon
In our fast paced world, with internet trading and instant gratification, it is popular to look for quick returns through schemes and strategies that carry undue risk. Benjamin Graham and Warren Buffett have taught the virtue of patience and the willingness to hold investments for long periods of time.
The markets will not always recognize the value in an investment immediately after your purchase. Sometimes patience, time, and a longer term horizon are required before your investment is ready to harvest.
2. Take Advantage of Mis-priced Markets
Graham used the parable of Mr. Market to illustrate the fact that investments are often mis-priced, sometimes overvalued, and other times undervalued. It makes sense to capitalize on mis-priced investments in order to increase your probability of making a profitable investment.
Valuation Analysis is the discipline of weighting your asset allocation based on valuation. Asset categories which are expensive should be avoided or underweighted, and categories that are bargains may deserve an overweighting.
3. Require a Margin of Safety
The core concept of margin of safety is: price matters! The lower the price you pay, compared to the real value of the investment, the greater the probability that your investment will be profitable.
Purchasing investments at a deep discount reduces the risk of owning that asset. The margin of safety allows for problems, mistakes, or unforeseen disasters. Negative surprises may have less impact on an asset that is already priced low.
At the same time there is more upside to investments bought at a large discount to its real or intrinsic value. As time passes, eventually the market should realize the true value of the investment, and provide a sales price closer to that value. The larger the margin of safety the higher your probability of above average returns.
4. Rebalance Your Portfolio (Often)
Portfolio rebalancing is a risk management strategy in which you buy or sell investments to achieve your desired asset allocation percentage. As asset prices increase or decrease the total value will depart from your desired asset allocation target.
Portfolio rebalancing helps an investor to buy low and sell high. This is because the strategy involves achieving your target asset allocation by selling a portion of the assets that have risen in price and buying more of the assets that have fallen in price.
5. Preserve Your Capital
Preservation of Capital should be an investors highest priority. Warren Buffett famously said “Rule # 1: Never Lose Money; Rule # 2: Never forget Rule #1.”
5 Portfolio Risk Management Strategies
To be a successful investor you need to understand how compounding works for you and against you. If you lose 50% and gain 50%, you still have a 25% loss! These rules of mathematics make capital preservation extremely important.
Conclusion: Thinking Differently From the Crowd
These 5 value strategies provide a foundation for making sound asset allocation decisions. Use the value strategies of time and long term investing, valuation analysis timing, margin of safety, portfolio rebalancing, and capital preservation to lower your risk and improve your probability of above average returns.
Investors with the ability to develop patience and focus on value strategies will avoid investments at high prices when everyone else is bullish. However, when investments are being crushed by pessimism an astute value investor has the ability to snap up good values at bargain prices.
Many investors invest too aggressively, especially when valuations are not favorable for high returns. If you keep bear market losses small it’s easier to get back to break even and the move to a positive return. But if you lose a large portion of your portfolio you have lost the investment capital to buy at favorable prices and make it difficult to recover your portfolio losses.
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