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Asset Allocation: Is it Necessary or Effective?

October 29th, 2009

Asset_allocation Asset allocation is a device used by investors and financial planners to populate a portfolio with an appropriate mix of investment vehicles selected from a smorgasbord of stocks, bonds, and occasionally other investments, each deemed to carry with it a uniquely predictable degree of risk.

Its goal is to optimize the return on the portfolio while taking into account  that investor’s tolerance for risk. And, risk aversion is analyzed using such factors as the point the client has reached in her life cycle, her current and future responsibilities, her earning capacity—as well as the nuances of his or her character and personality.

The assumption is that there is an inverse relationship between risk and return; and, the more aggressive the portfolio—one invested primarily in common stocks—the more risky it is.

Few amateur investors have the experience or know-how to apply asset allocation without the help of a professional. And, considering the view that most amateurs have of “investing,” the expense of such a professional might easily be justified. But….


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This week: What’s your portfolio really worth?


I agree with Peter Lynch’s view that one should invest as if she were going to live forever. In my view, the most aggressive portfolio should be expected to generate no higher a return than the potential growth rate of a basket of well managed companies’ earnings—between 10% and 15% a year. And that there’s simply no need to dilute the return of a portfolio with any investment vehicles that would return less than that. I believe that’s all the “asset allocation” anyone needs!

The secret is to recognize that there is virtually no risk when you select those companies for their ability to grow their earnings consistently and adequately; and when you understand that the oscillations of the stock market—and the prices of the shares of the companies you own—have nothing whatever to do with the operation of those companies and the generation of profits for their owners. And, as an owner, you’re in it for those profits!

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  1. Gary Simms
    October 30th, 2009 at 11:10 | #1

    Our former local director, Bert Sanders, once presented this graph of historical asset performance and asked me to find the pattern in it.

    http://biwiki.editme.com/AssetAllocationHx

    I was unable to see any pattern and admitted such.

    Bert explained he too could see no pattern and he deduced that’s why assset allocation was necessary.

    I can understand your reasoning that a portfolio of stocks yielding between 10 & 15% per year return is all you need. I further understand your use of rational value. This is fine as long as you have time on your side so fear can disappear from the market and the rational value of the stock can return, but recent retirees lack this element of time and/or the emotional foresight to endure the depressed market.

    John Bogle said in his first book, Bogle on Mutual Funds, New Imperatives for the Individual Investor, bonds did NOT add to the return of the portfolio. Rather they lessened the volatility of the portfolio’s value. You hold bonds so you can sleep at night – that’s an emotional reason. Nothing rational about it. But as we found out last year, rational or not, emotion is real.

    All that said, I only hold US stock, bonds, cash, and real estate.

    • October 30th, 2009 at 13:05 | #2

      I can understand your reasoning that a portfolio of stocks yielding between 10 & 15% per year return is all you need. I further understand your use of rational value. This is fine as long as you have time on your side so fear can disappear from the market and the rational value of the stock can return, but recent retirees lack this element of time and/or the emotional foresight to endure the depressed market.

      I guess I’m just inadequate when it comes to getting a point across; and I’m pleased that your comment points up that failure.

      Gary, the “Rational Value” of the stock doesn’t return. It never left! That value remains all the time, whether the market price reflects it or not!

      I’m a retiree, going on 80. And I depend upon my holdings to maintain my quality of life. I’m not going to act any differently while I “wait” for the market value of my holdings to come back.

      When we put aside money for retirement and we invest, we’re adding to our holdings and it makes sense to dollar-cost-average simply because we’re able to buy more shares when the price is low than when they’re high. So our cost per share benefits from it. That’s on the up-side as we accumulate.

      When we retire, we’re no longer on the up-side. We’re “de-cumulating.” And, so far as I’m concerned, dollar-cost-averaging will simply work in reverse. We can’t accumulate when we’re in the de-cumulating mode. All we can do while we’re “waiting” (and I don’t consider myself to be waiting) is to try to be a little more prudent about our spending while the herd sells to the enlightened investors and they begin to bid the price back up where it belongs. The odds are very good that the herd will even do us the favor of climbing back on the bandwagon and, once again in our lifetimes, bid the prices up to where they’re once again above and beyond their rational value. And we’ll then be the beneficiaries of that happening.

      But I don’t really think that, by keeping my money in the ownership of good quality companies that continue to earn for me, I’m losing nearly as much as I would by moving it into things that don’t have the potential to come back to normal or even do better—that “normal” providing a return of between 10% and 15% as compared with 5% or 6%. I would lose lots of sleep over that!

      The very worst thing anyone could do at the bottom of a market is to capture the losses in their common stock holdings and replace those stocks with bonds and other vehicles with a fixed return far below the potential return from the resurrection of the common shares. It would be bad enough to let your position on your life cycle persuade you to accept a 5% or 6% return, with no possible increase, instead of a 10% to 15% return. But, to miss out on all the additional PE expansion in a recovering market would be insane!

      Anyway, with this philosophy, I haven’t lost a moment of sleep—even when the proverbial fan got hit! I believe our goal should be to help others understand this position and improve their risk aversion rather than to teach them to succumb to a policy that would reduce their return with no real decrease in that risk.

  2. michele
    November 7th, 2009 at 05:23 | #3

    please add me to your e-mail list

  3. November 7th, 2009 at 12:29 | #4

    @michele
    I’ve subscribed for you. Thanks.

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