Wealth Building Lessons

One of my wife’s childhood friends asked me a very profound question. “You know a bit about investing, don’t you? So what’s asset allocation?”. The friend is pretty smart. She went to school for several years and became a pharmacist and can rattle off various diseases, symptoms, drugs and side-effects which I find quite entertaining (somehow my wife doesn’t share my enthusiasm for “Stump the Pharmacist”). But she doesn’t know anything about investing (or much about anything money-related for that matter).

Very simply, since most people can’t predict which sector of the stock market will do well next year, they diversify their portfolio into various non-correlated sectors thereby ensuring they get the average return and preventing significant losses in case one particular sector does poorly.

For example, if you were 100% in technology stocks in 1999, you probably got decimated in 2000. However, you you had no more than 20% of your portfolio in tech stocks and the remainder in REITs, energy stocks, foreign stocks and bonds, you probably did ok.

Asset Allocation is commonly divided in terms of Market Sectors and Market Capitalizations of the companies.

Here are some common sectors:

• Cash (i.e., CDs and money market accounts)
  
• Bonds: investment grade or junk (high yield); government or corporate; short-term, intermediate, long-term; domestic, foreign, emerging markets
  
• Stocks: value or growth; large-cap versus small-cap; domestic, foreign, emerging markets
  
• Real estate/REITs
  
• Foreign currency
  
• Foreign investments (international emerging market equities or bonds)
  
• Natural resources (like timber, oil and gas)
  
• Precious metals
  
• Luxury collectables such as art, fine wine and automobiles
  
• Other

You can further break down equity investments into additional asset classes
By size:

• Large-Cap
  
• Mid-Cap
  
• Small-Cap
  

By style:

• Growth
  
• Blend
  
• Value (sometimes called Income)

There’s also another subset called Tactical Asset Allocation. According to Wikipidia,

Tactical asset allocation is a method of investing in which investors modify their asset allocation according to the valuation of the markets in which they are invested. Thus, someone invested heavily in stocks might reduce his position when he perceives that other securities, such as bonds, are poised to outperform stocks. Unlike stock picking, in which the investor predicts which individual stocks will perform well, tactical asset allocation involves only judgments of the future return of complete markets or sectors.

Since I believe in the long term devaluation of the dollar, most of my stock investments are in foreign stocks, commodity/mining/metal stocks, oil/gas. You could call this tactical asset allocation, since there’s an element of prediction involved.

But lets see what the world’s greatest (or atleast famous) investor, Warren Buffett says about asset allocation. You can always rely on him to cut to heart of the matter without any BS. (Couldn’t find a direct quote, so here’s a quote via Dan Ferris)

“Your default position should always be short-term instruments. And whenever you see anything intelligent to do, you should do it.”

Buffett also said that asset allocation, a Wall Street obsession, is pure nonsense.

Asset allocation is Wall Street BS for when Abby Jo Cohen announces in a very pompous way that she’s now going to recommend you have 65% of your money in stocks and 35% in bonds, when before it was 60% in stocks and 40% in bonds. People actually pay a lot of money for that kind of advice. Educated people. People who would otherwise impress us with their connections and money and power. God only knows why they can’t see that asset allocation is a total scam. It’s completely and totally unnecessary.

If you want to know what to do instead of worrying about asset allocation, remember this: “The best way to minimize risk,” says Buffett, “is to think.”

But the average person doesn’t know how to think when it comes to investing. So you’re better off at least understanding asset allocation and what your exposure to various sectors is. And if thats still too complicated, you might want to stick to a broad market index fund.

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