Asset Allocation

Another night in any town
You can hear the thunder of their cry
Ahead of their time
They wonder why
--Journey

Previously we discussed the primary asset classes available to investors: cash, fixed income, equities, and alternative assets. How investors blend them together in their portfolios is known as asset allocation (AA). Studies suggest that AA matters more to investment returns over time than does the choice of particular securities inside each asset class.

Asset allocation is a personal thing, meaning that there is no one particular allocation pattern right for everyone. An individual's AA can depend on many factors including age, personal tolerance for risk, one's general view of the world, and estimation of value offered by risky asset classes.

Let's see how these factors associate with three model AA patterns that employ various combinations of the four primary asset classes. (Note, however, that this is for demonstration purposes only. Portfolios do not have to be invested in all four asset classes.)

1) "High cash" portfolio: 60% cash, 20% fixed income, 10% equities, 10% alternative assets.

High cash portfolios are attractive for older people who need more certainty from their investments during retirement. People with lower risk tolerance will also prefer more cash. This particular AA is also 'defensive' in nature. If you have a pessimistic 'macro' outlook, or if you believe that risky asset classes such as stocks are overvalued, then cash-rich portfolios are also a good fit. Note that alternative assets such as gold help offset the risk of holding lots of cash--if the purchasing power of cash declines because of inflation, then gold and other hard assets usually increase in price to compensate. Also note that equities in high cash portfolios often consist of large stalwart company stocks that pay steady dividends.

2) "Balanced" portfolio: 25% cash, 35% fixed income, 35% equities, 5% alternative assets.

Balanced portfolios are spread more evenly among the three 'traditional' asset classes of cash, fixed income, and equities with perhaps a sliver of alternative assets for insurance. Middle aged individuals and those with a medium risk tolerance match well with balanced AAs. People who have no strong views either way when it comes to state of the world or valuation of risky assets also tend to be good fits with the balanced approach. Balanced portfolios can be a good in-between step for people who want to move toward more extreme 'risk on' or 'risk off' positions in the AA spectrum. By seeking balance first, those individuals can sense whether they are moving in the right direction.

3) "Growth" portfolio. 10% cash, 10% fixed income, 75% equities, 5% alternative assets.

Growth portfolios are characterized by high allocations toward equities. As a general rule, equities carry the most potential for reward--but they also carry the most potential for loss (read: risk). The high risk:reward profile of growth portfolios is a good match for young people since their age allows them to time to a) participate significantly in bull market runs and b) recoup losses that happen periodically in bear market declines. Growth AAs also attract individuals with high risk tolerance. If you have an optimistic macro view of the world, and/or you think that stocks and other risky assets are undervalued, then growth-oriented asset allocations match well with your outlook. Growth portfolios sometimes ditch the insurance of alternative assets to gain a bit more 'juice' from their capital (for better or worse).

Again, the above AAs merely demonstrate some possibilities. How you tailor your particular portfolio, and how you adjust it over time, is unique to you.