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Investment Asset Allocation

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. Please enjoy reading this article. Thank you!

Step 5 – Manage investment risk and return through asset allocation

Your risk and return preferences relative to the average investor who hold the average portfolio will influences your choice of a portfolio asset allocation. Appropriately setting your personal asset allocation in line with your personal risk tolerance is a critical decision for every investor. Because the average risk-averse investor holds the average portfolio asset allocation, this becomes the starting point in determining how a specific individual’s portfolio might diverge from that average allocation. Periodic rebalancing over time maintains your intended expose to investment risk and return.

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 tend to off-set each other to some degree. 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?

Whether you invest through broadly diversified index mutual funds or diversified exchange-traded funds (ETFs), the largest and most established financial asset classes are stocks, bonds, and cash. Stocks, bonds, and cash are sometimes referred to as financial assets, and most financial assets are priced and traded publically 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.

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 by the financial industry. A few of the alternative asset classes and associated investment products that are pitched to individual investors include: various commodities, gold, foreign exchange, hedge funds in 57 varieties, infrastructure, managed futures, private equity, limited partnerships, and on and on.

Once you stray beyond public market 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.1 Promoters suggest that the grass is greener with these alternative asset classes, but many seem more like swamps upon closer inspection. In general, this alternative investment swamp is characterized by false or misleading performance claims, excessive sales fees, excessive costs, excessive risks, and excessive taxes.

If you are not highly sophisticated in financial analysis (and even if you are), you can do fine and probably a lot better, if you stay away from these alternative asset classes entirely. Individual investors can do quite well across their lives by sticking solely to the cash, bond, stock and real estate asset classes for their entire investment portfolios.

Your personal investment risk tolerance should determine your investment asset allocation

Investing always involves risk. 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. An investor’s ability to tolerate risk 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 personal limitations and choose the appropriate investment boat, given their risk tolerance and fortitude.

Setting your personal investment asset allocation is a critical decision for every individual investor.

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. Unfortunately, few will enjoy themselves during this 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 aggregate values and relative proportions of the financial markets will define this average asset allocation. Then, the relevant questions to ask are: “How does my personal risk tolerance compare to the average investor and how should my personal asset allocation differ from that of the average investor?”

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.

Before the Credit Crisis: 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.2

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.3 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-2004.4

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. 5 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. 6 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.

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 other financial adviser will get paid commissions 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 also might be a very good time to head for the door. An advisor who uses a commission motivated investment product sales strategy can be a large problem for you rather than the solution you are looking for. Remember that it is your money in play — not his. Pay very close attention to your advisor’s sales incentives. High cost and high fee investment products will be the highlight of the conversation. When the sales incentives disappear, so does this kind of “financial advisor.”

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.

Lawrence Russell and Company Pasadena, California 91103

(626) 399-9579

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A truly independent financial planner and fee only investment advisor

(Regarding how I am compensated, I perform services only on a hourly fee or fixed fee for service basis, and only under a contract that would be agreed upon with you. You will not have to pay any form of asset fee. In addition, to avoid any conflict-of-interest, I do not accept commissions or compensation of any type from the financial industry.)

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1) For example, holding gold has become a popular alternative asset class. Investors looking for gold bullion coins and bars will often use private sellers. However, where would they go, if they want gold securities and options, instead of holding the gold physical assets directly? Alternatively, should they hold gold mining equities? How do they decide? The choices can be bewildering for the average investor.
2) Federal Reserve Bank, Federal Reserve Z.1 Report. June 10, 2004.
3) 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.
4) 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.)
5) 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.)
6) 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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