Investment Asset Allocation

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.

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. Of course, none of this loud investor demand has anything to do with us in the financial services industry loudly promoting these great future investment opportunities based on our back-fitted, data mining discoveries of selective “coulda-shoulda-woulda” superior historical investments.

“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. Pay no attention to the ‘Nerds on Wall Street‘ behind the curtains.

“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 silk tie I have isn’t it? Let me tell you about the swell tropical place I stayed, when I was on vacation. Oh, just sign here, while we chat.”

Heard this one before? Did you put in your money? How did it work out? How did you sleep?

An individual’s risk preference relative to that of the average investor influences the asset allocation that would tend to be most beneficial from a risk-adjusted portfolio performance point-of-view.

Your personal investment risk tolerance should determine your investment asset allocation. Investment always involves risk. If your personal capital is not at risk, you simply are not holding an investment. All investors — small or large – skilled or unskilled — irrational or rational — sophisticated or unsophisticated – must navigate the same uncertain securities market and economic waters to get to their financial goals. While investing involves significant complexity, much of which is unnecessary, an investor’s ability to tolerate risk or the occasional, inevitable, and unpredictable stormy waters will dictate whether they can stay in the markets in the bad times, as well as the good times.

By analogy, those who cannot tolerate rough waters, should sail in a bigger, safer, and slower boat (more cash and bonds and less stocks). Those who can better stomach the storm can sail in smaller, faster boats (more stocks and less cash and bonds) and perhaps go faster while exposing themselves to greater risk. On average historically, greater risk has yielded greater rewards, but investors need to be aware of their limitations and choose the appropriate investment boat, given their risk tolerance and fortitude. If the average investor sails in the average investment boat, then the more risk averse investor should choose a larger, slower boat, while the more risk tolerant investor should choose the smaller faster boat. Risk tolerant investors tend to be frustrated by the lower performance of slow boats, while risk averse investors in small fast boats may experience fears and losses (however temporary) that they simply cannot tolerate.

Virtually all investors are risk averse to some degree. Therefore, securities markets are expected to pay a positive, albeit uncertain, future return or risk premium. Otherwise, no investor with greater or lesser risk aversion would be willing to put their capital at risk versus storing their money in a more certain asset with lower risk. Those few who crave risk have casinos or day trading or Forex or commodities or some other  ”zero-sum-plus-costs” game, where they can give their money away to the “house” slowly or quickly — and hopefully they enjoy themselves during that foolish process.

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. The question becomes: “What is the average asset allocation of the average investor?” The aggregate values and relative proportions of the financial markets will define this average asset allocation.

Defining the average asset allocation of the average individual investor

For the rest of this discussion, we will focus on getting rough estimates of the primary financial asset classes — cash, bonds, and stocks — to develop a point of reference for the “average investor.” Of course, there are other asset classes that some individual investors hold, such as real estate and private business interests. These other classes need to be taken into account when developing a comprehensive family financial plan. Nevertheless, cash, bond, and stock financial asset interests tend to be the most easily changeable in their composition. Each of these financial asset classes can be readily converted into the other through modern real-time securities markets, and thus an asset allocation plan with infrequent rebalancing is prudent.

Measuring the average asset allocation of the average investor is therefore the goal. This should be pretty simple, correct? Just measure all financial assets held directly or indirectly for the benefit of individuals (in our case US residents) and figure out the proportions of cash, bonds, and stocks. These asset class proportions then become the average asset allocation reference point for the average investor. A more risk averse investor would then hold a portfolio the skews toward less investment risk, and the converse would be the case for a more risk tolerant investor.

However, this is only half of the puzzle, because the average asset allocation is not always stable over time. Economic cycles and securities market cycles exist, and their movements are correlated. The economy grows more quickly at some times and goes into a reversal during recessions and depressions. Securities market cycles tend to anticipate business cycles, but without any reliable assurance that the direction and strenght of current securities market anticipation is accurate. The prescience of securities markets can only be measured in hindsight, after changes in the economy have become clear and the future that was anticipated by securities markets becomes the past or history.

Since the turn of the century and the millennium, the US and the world has experienced extraordinary financial times. Two decades of expansion in the 1980s and 1990s peaked in a technology/communications/financial bubble that collapsed in 2001 and was followed by an anemic recovery and growth cycle from about 2003 to 2007. Without strong US job growth in this growth cycle and driven by rising US consumer debt obligations and a US housing value bubble, the US then lead the world into another financial or “credit crunch” crisis that was far worse than the dot com crash.

In the fall of 2008, the world stared into the abyss of global financial crisis, akin to Calypso’s maelstrom in “Pirates of the Caribbean: At World’s End.” It did not matter whether you were in a big slow investment boat or a small, speedy investment boat. Without the real world “special effects” of massive global government intervention in the securities markets, we would have found the end of this unfolding securities horror movie would have been to find most large boats and all small boats in Davy Jones locker at the bottom of the economic ocean.

In panic, those who could not stomach this maelstrom fled to the “dry land” of government guaranteed cash investments, and away from stocks and even bonds. The remainder of this article provides a few numbers that tell this disturbing financial tale. For purposes of setting an asset allocation strategy, one needs to decide whether to pay attention to the average asset allocation “normal” of the last several decades or to decide that what we just have collectively endured is the “new normal,” which it likely is not.

Average Asset Allocation Percentage Data for 2004

To understand the overall asset allocation percentages of the major financial asset classes, in mid-2004 I performed a detailed analysis of all US personal financial asset ownership held directly by individuals and indirectly by institutions for the benefit of individuals. Concerning the average portfolio of the average investor, I 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. Analyzing the Federal Reserve data takes quite a bit of time, whereas the ICI data can be analyzed and understood much more quickly.

The average asset allocation at the mid-point of economic and securities market cycle can serve as a baseline for the asset allocation of the average risk-averse investor.

Therefore, if we summarize the Federal Reserve Z.1 assets data and the ICI mutual fund assets data for 2004, about 27% of assets were in cash and equivalents, 19% were in bonds and fixed income assets, and 54% were in stock and equity assets. With the benefit of several years of subsequent hindsight, the end of 2004 was roughly the middle of the last combined business and securities market cycle.

For an asset allocation comparison taken near the tail end of the market cycle prior to the credit crunch debacle of 2008/2009, I 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/economic cycle 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 2004 to 2007 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 an average individual investor’s asset allocation would be.

What happened to the average asset allocation during the recent credit crisis of 2008 and 2009?

While we can only hope the the credit crunch, financial markets crash, recession, and near depression of 2008 and 2009, is an aberation and not the new normal, it is instructive to look at a few data points to see what happened to the apparent asset allocation percentages at certain points during this crisis. Here I will use ICI mutual fund data.

Following a grinding decline in stock market values beginning in late 2007 and culminating in the free fall collapse of equity values near the end of 2008 and beginning of 2009, the stock markets bottomed out in March of 2009. The the equity markets began a recovery that was surprising to many if not most investors. (Note that this is being written in October of 2009 and thus I cannot predict (nor can anyone else) what will happen going forward.)

Measured at the end of the first quarter 2009, the ICI reported total US domiciled mutual fund assets of $9.2 trillion dollars or very close to 50% of the $18.2 trillion dollars in mutual fund assets held by investors across the globe. ⁴ For US mutual funds, 41% of total assets were held in cash equivalent money market mutual funds, 20% of assets were held in bond funds, and 39% of assets were held in stock or equity mutual funds.

In effect, when compared to the 2004 and 2007 figures above, there was roughly a 15 percentage point shift from stock funds to money market funds.(In aggregate the total value of US mutual fund asset almost $3 trillion lower than the total value near the end of 2007.) While only a small part of this shift in percentages can be was due to actual net redemption cash flows out of stock funds, the real explanation was that the collapse of stock market values accounted for the vast majority of the shift in overall percentages. Assets did not have to move. Equity values had just collapsed, as expectations about the future economy contemplated a severe depression.

And then the recovery of 2009 reversed trends in aggregate asset allocation percentages

Now, let’s take a look at the latest available figures at the time of this writing, which were for the end of  September, 2009. ⁵ The ICI reported total US domiciled mutual fund assets of $10.6 trillion dollars representing an increase in total mutual fund asset values for about $1.4 trillion in that six month period. For these US domiciled mutual funds, 34% of total assets were held in cash equivalent money market mutual funds, 21% of assets were held in bond funds, and 45% of assets were held in stock or equity mutual funds. In effect, when compared to the end of March 2009 figures above, there was roughly a 6 percentage point total value shift in favor of stock funds and a 1 percentage point shift in favor of bond funds — all away from money market funds. Again only a  small part of this shift in percentages can be accounted for from actual net cash in-flows into stock funds.

The vast majority of the last six months of equity market appreciation was due simply to a recovery of equity market values and not due to cash in-flows. Those who were in the market benefited with paper gains, just as the vast majority of them had paper losses as the markets collapsed in 2008 and early 2009. The real question is whether current aggregate asset allocation percentages are the new normal, or just a transition from a severe securities market crisis back toward the historical norm. This is a critical asset allocation decision for investors.

If you were an average investor and held the average asset allocation of 2004 to 2007 and had an investment policy to retain that asset allocation through periodic re-balancing, then you would have been a net buyer of equity assets as securities market values collapsed in 2008 and early 2009. While perhaps emotionally challenging to anyone, this “buy equities into a crisis” (and “sell them into a growth cycle”) strategy would have positioned you for the recovery that occurred in 2009. Most who flew to cash did so after most of the collapse in equity values had already occurred (buy high and sell low), and they were sitting in cash on the sidelines in surprise as equity market values recovered. The investment research literature has repeatedly shown that market timing is an inferior strategy. In the next few years, we will undoubtedly seem more studies that repeat this finding. Even if another maelstrom reoccurs, this will be yet another opportunity for investors to achieve dramatically inferior portfolio performance, when they do not have a well-defined long-term asset allocation and re-balancing strategy in place and when they do not have the will to implement it consistently over time.

This article continues below this introduction:

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Larry Russell, Managing Director

MBA – Stanford University, MA – Brandeis University, and BS – M.I.T.

Lawrence Russell and Company Pasadena, California 91103

A California Registered Investment Adviser — Certificate 133101

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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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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.” Note that while the balanced or mixed mutual fund category is relatively small and usually constitutes about 5% of total mutual fund assets, this category consists mainly of bonds and stocks. For purposes of analysis, I assumed that the proportion of assets in the balanced or mixed category was 50% bonds and 50% stocks and I allocated these dollar amounts to the primary bond and stock asset categories to eliminated the mixed category.
3) Investment Company Institute. “Trends in Mutual Fund Investing, November 2007″ (The same procedure for balanced or mixed mutual fund assets as decribed in the note above was applied.)
4) Investment Company Institute. “Worldwide Mutual Fund Assets and Flows, First Quarter 2009″ Supplementary Table S4 (The same procedure for balanced or mixed mutual fund assets as decribed in the note above was applied.)
5) Investment Company Institute. “Trends in Mutual Fund Investing, August 2009″ (The same procedure for balanced or mixed mutual fund assets as decribed in the note above was applied.)

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