5 - Investment Asset Allocation
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Step 5 of 10 Personal Financial Planning Steps in the Right Direction
This is one of the “10 Steps in the Right Direction” that make up The Pasadena Financial Planner’s personal financial planning and personal investment management process. For a summary of these ten steps, see Your Family Financial Planning. To find an in depth article for each step, just click the Sitemap link at the top of this page. Also, you can reach us by using the contact form below, and you can subscribe to our Objective Family Financial Planning Blogs by clicking the orange RSS icon to the left. Please enjoy reading this article. Thank you!
Setting your personal investment asset allocation is a critical decision for every individual investor.
Asset allocation can be viewed as an extension of the Global Investment Diversification Strategy principle to multiple types of assets, such as equities versus fixed income securities. Asset allocation is also how you blend your personal investment risk preference into your investment asset portfolio.
Appropriately setting your personal asset allocation in line with your personal risk tolerance is a critical decision for every investor. The percentages that are allocated to various asset classes tend to change slowly over time, so it is important to get it right at the outset.
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Investing and asset allocation is all about risk-adjusted investment returns related to your overall investment asset portfolio. Because the risk and return characteristics of various asset classes are not completely correlated, changes in their market prices sometimes off-set each other. Therefore, you normally can assemble an investment portfolio with lower overall investment risk, when compared to the risk of each of the individual asset classes that make up your portfolio. In effect, the various asset classes provide additional diversification benefits that go beyond the investment risk reduction benefits that can be achieved through full diversification within each individual asset class.
What is an investment asset class?
At the outset, a word of caution about the proliferation of “asset classes” promoted to individual investors is useful. Whether you invest through broadly diversified index mutual funds or diversified exchange-traded funds (ETFs), the largest and most established investment asset classes are stocks/equities, bonds/fixed income, and cash/cash equivalents. Stocks, bonds, and cash are sometimes referred to as financial assets, and most often these financial assets are priced and traded on real-time securities markets.
Real estate property is an additional asset class, which creates some complications related to portfolio diversification. The great majority of individual investors with some financial assets also tend to be real estate property owners. For many, their real estate assets - usually their personal residence - can grow in value over their lives to become a very substantial and even majority part of their personal investment asset portfolios. Since this real estate equity is in a homes, which also provides shelter, then these real estate assets really function as a financial asset reserve of last resort after equity, bond, and cash financial assets are exhausted, usually during retirement.
Common stocks, which are one of the largest and most well established investment asset classes in the world, have been sliced and diced into a myriad of confusing segments.
The financial services industry is ingenious in its invention of new asset classes and its balkanization within even traditional investment asset classes. You may already be aware, for example, that the stocks or equities asset class already offers a large boatload of investor confusion. Even if you decide to invest only in mutual funds and/or ETFs for diversification and you intentionally avoid the daunting task of picking individual stocks, you still are confronted with extraordinary complexity. Stock investment fund choices include: small-cap, mid-cap, large capitalization, domestic, international, global, value, growth, core, sector, industry, hybrid, long-short, socially conscious, green, active, passive, index, Class A shares, Class B shares, Class C shares, and on and on and on.
Armies of securities industry sales and advisory personal compete for your attention and advocate that you assemble your personal portfolio according to differing and supposedly superior portfolio optimization techniques. Often, it is unclear whether these asset class segment inventions truly are beneficial to investors. Of course, the associated fees seem to guarantee that this segment proliferation will always be beneficial to the securities and financial services industry. The more complex things get, the more you seem to need someone to help you to fiddle with and to rebalance your portfolio. That, of course, costs more, too. Plus, you get to pay more repeatedly, because the fiddling never stops in this noble pursuit of more optimal risk-adjusted portfolio returns. Unfortunately, the additional costs most often outweigh the additional benefits.
Non-traditional investment asset class concerns
Beyond stocks, bonds, cash, and personal real estate holdings, there are numerous other perhaps real, but very often fanciful or false asset classes that are promoted to individual investors. A few of the alternative asset classes and associated investment products that are pitched to individual investors include: commodities generally, gold, foreign exchange, hedge funds in 57 varieties, infrastructure, managed futures, private equity, limited partnerships, variable annuities, etc. Once you stray beyond stocks, bonds, cash, and real estate, the proliferation of additional asset classes and investment vehicles seems virtually unlimited.
Unfortunately, many of these alternative asset classes and investment products are fraught with problems for less sophisticated (and even for more sophisticated) individual investors. Here is the rub. How can you tell whether an alternative asset class might genuinely be beneficial to add to your portfolio? Which of them should you hold?
Generally, the alternative investment asset class sales argument goes as follows:
“A) This special ‘new asset class’ has had very high returns. While this asset class also has had very high risk, if you had put this new investment asset class into your portfolio in the past, the risk would have been moderated. That is because values in this new asset class historically has zigged, when values of the other investment asset classes have zagged.
“B) Therefore, this new investment asset class might increase your future returns and could even reduce your portfolio’s overall risk. This is a great opportunity for you. You should put 5%, 10%, or x% of your total assets into this asset class. We have introduced some swell new investment products that address this asset class. It is too bad that you did not buy these investments years ago, before the run up in values. Unfortunately, we did not offer these investment products back then, because we have only introduced them recently in response to the loud clamor of investor demand.”
“C) Pay no attention to the high fees and high costs of buying into this asset class with these new investment products. These extra costs are small in comparison to the potential payoff to you. Pay no attention to those naysayers behind the curtain, who may argue that historical performance is not predictive. Ignore their suggestions that this asset class was just cherry picked from the historical investment returns records, because of its past performance.
“D) Do not listen to anyone who says that you could be paying a very high price to put a lot more risk into your portfolio with no assurance of a superior payoff in the future or reduced risks. What is that you say? You want a guarantee. Oh my, I am sorry, but there simply are not guarantees in investing. However, do not worry now. You can just trust me. We have done our research. See this 4-color brochure on the product? This is a nice tie isn’t it? Let me tell you about the place I stayed, when I was on vacation. Oh, just sign here, while we chat.”
Your personal investment risk tolerance should determine your investment asset allocation. An individual’s risk preference relative to the average investor influences the asset allocation that will be chosen.
Because the average risk-averse investor holds the average portfolio asset allocation, this becomes a reference point in determining how a specific individual’s investment portfolio asset allocation might diverge from that of the average investor’s asset allocation. For example, to understand the overall asset allocation percentages of the major financial asset classes, in mid-2004 we performed a detailed analysis of all US personal financial asset ownership held directly by individuals and indirectly by institutions for the benefit of individuals. Because the relative values of financial asset may change over market and business cycles, mid-2004 was chosen arbitrarily as roughly the mid-point of the most recent economic and market expansion cycle.
Concerning the average portfolio of the average investor, we reviewed detailed data from the US Federal Reserve Bank which tracks total personal assets across all kinds of personal accounts including brokerage, tax deferred, pension, insurance, trust, and other accounts. The Fed’s June 2004 Z.1 report indicates that total U.S. personal financial assets were approximately $26.9 trillion dollars. In total in mid-2004, the percentage allocation across the major financial asset classes was 26.9% in cash and equivalents, 18.9% in fixed income, and 54.2% in equities.1
For purposes of comparison, the Investment Company of America’s (ICI) end of 2004 estimate of total US domiciled mutual fund assets, which is a subset of the personal assets that the Fed tracks, totaled $7.5 trillion dollars.2 The percentage allocation was 27.7% in cash and equivalents, 19.7% in fixed income, and 52.6% in equities. The mid-2004 Federal Reserve and the end of 2004 ICI numbers are remarkably similar. This gives confidence that these figures represent approximately the average asset allocation of the average personal portfolio.
These figures serve as a baseline against which individual investors can compare their asset allocation in relation to that of the average risk-averse investor at the mid-point of a business and securities market cycle.
For an asset allocation comparison taken near the tail end of a market cycle, we also looked updated ICI data for total U.S. domiciled mutual fund assets in November 2007. (U.S. domiciled mutual funds would include both domestic and international stock, bond, and cash investment assets.) The ICI reported that, at the end of November 2007, U.S. domiciled mutual fund assets totaled $12.1 trillion, which is about a 60% increase over total assets in mid-2004.3
Even with this huge, $4.6 trillion increase in total mutual fund value, the late 2007 percentage allocation was 25.7% in cash and equivalents, 17.0% in fixed income, and 57.7% in equities - again reasonably similar to mid-2004 with a moderate shift of value toward equities. The proportion of asset value in the equities asset class rose about 5 percentage points, as the business and securities market cycle advanced and matured.
Meanwhile the proportion of asset value in both cash and debt securities declined modestly. Cash has been redeployed somewhat, and bond asset values have declined as debt instruments have came under pressure in the credit crisis of the second half of 2007. Nevertheless, the change in percentages has not been dramatic. These figures demonstrate that, overall, about 55% of total asset value is held in equities, about 25% in cash, and somewhat shy of 20% in bonds.
These proportions represent the average holdings of the “average” investor across all personal financial assets held in U.S. personal accounts, either directly or indirectly through institutional holdings on their behalf. Depending upon your relative tolerance for investment risk compared to the “average investor,” these average percentages are instructive concerning what your optimal asset allocation would be.
Professional advice about your personal investment portfolio asset allocation
If you are confused by asset allocation and all these investment product choices, hire a genuinely competent, knowledgeable, and objective financial advisor to help you. However, if your financial advisor or investment counselor is the one promoting alternative investment classes, perhaps you might want to run the other way.
In particular, you might want to run away, if your stock broker, investment counselor or financial adviser will get paid to sell these alternative asset class investments to you. Furthermore, if you answer just a short investment risk questionnaire and your investment advisor quickly classifies you as a conservative, average, or aggressive investor, be wary. If your advisor quickly starts selling, this might be a very good time to head for the door. An advisor with wrong strategy on commission can be a very large part of the problem rather than the solution.
For more information about personal investment portfolio asset allocation, see these articles on “Asset Allocation and Personal Investment Risk Tolerance.” These articles are published on our sister website, The Skilled Investor. Again, you can subscribe to our Objective Family Financial Planning Blogs by clicking the orange RSS icon to the upper left.
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Larry Russell, Managing Director
MBA — Stanford University, MA — Brandeis University, and BS — M.I.T.
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Lawrence Russell and Company Pasadena, California 91103
A California Registered Investment Adviser — Certificate 133101
KNOWLEDGE — OBJECTIVITY — HONESTY — CONFIDENTIALITY — DILIGENCE — EFFICIENCY — SATISFACTION
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Footnotes:
1) Federal Reserve Bank, Federal Reserve Z.1 Report. June 10, 2004. http://www.federalreserve.gov
2) Investment Company Institute. “2004 Mutual Fund Fact Book.”
3) Investment Company Institutie. “Trends in Mutual Fund Investing, November 2007″
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