Modern Version of Asset Allocation
In my first posting I spoke about the benefits of the portfolio diversification and modern portfolio theory and last week I discussed absolute return strategies. Here I would like to propose a (relatively) new way to put the two together for better returns with lower risk.
As a quick reminder, a classical portfolio allocation would have your portfolio in different asset classes, for example 60% in stocks, 30% in bonds and 10% in cash. This is good, it is true and it will get you where you want to be in terms of diversifying your portfolio and reducing risk.
But there is better. Our investment world has gotten better (I believe) because generally speaking there is more transparency, there is more liquidity, but equally important is that there are more Ă˘â‚¬Ĺ“thingsĂ˘â‚¬Âť to invest in. Some of course might argue that that this makes our investment jobs harder because we have to do more quantitative and qualitative analysis, which is of course true. I think that the more things we can invest in the more choice we have. Saying it differently, the investor, who does his/her work performing good analysis, gets rewarded. This makes my job more interesting and more rewarding.Ă‚Â So I am all for choice and more opportunities.
So how do we harness more choice? I would like to share an updated version of asset allocation concept. Instead of allocating your portfolio among different Asset Classes (as mentioned above), I suggest we step back and allocate among different Asset Categories. Here is what I mean.
LetĂ˘â‚¬â„˘s create larger buckets of things to invest in. We started with three classes of financial instruments (stocks, bonds, cash), letĂ˘â‚¬â„˘s create even more diversified and broader categories. The first category would be financial instruments. Another category would be physical assets. Another category would be hard assets. Another category would be alternative assets. And another category would be absolute return assets.
The financial assets would include stocks, bonds and cash. This would constitute the core of our holdings, say about 50%. This category would include domestic and foreign stocks and bonds, corporate and government bonds and of course cash.
The physical assets I call goods such as commodities (oil, corn, etc.), which are continuously consumed. These are important because we eat food, drive cars, electronic industry needs precious metals. There will always be demand for this. You would allocate 10% of your portfolio to this asset group.
The hard assets are real estate, art (good art I would hope), classic cars, things that are kept, but not consumed. The real estate assets will grow over time, it is a simple matter of population growth. The aesthetic assets get older and by default more valuable. Their value is in the eye of the beholder, and there are many beholders. This asset group would be about 10% of your portfolio.
The alternative assets would be hedge funds, private equity, venture capital funds. This group of assets, as the song goes, Ă˘â‚¬Ĺ“move in mysterious waysĂ˘â‚¬Âť. What I mean is that the assets in this group are typically not correlated to major indices because their returns are realized over much longer periods of time and they donĂ˘â‚¬â„˘t fluctuate as much as major market indices. These are less liquid investments, although as you would expect they have higher returns and I would allocate about 10% here.
The absolute return asset would be what I mentioned last week and previous weeks. This asset group focuses on four methodologies of constructing portfolio baskets with uncorrelated returns, which deliver absolute returns in any market. These four methodologies are Portfolio Exposure, Asset Classes, Geographical Exposure, or Portfolio Construction. This group would take 20% of your portfolio. The reason for such relatively high number is because these absolute return assets provide stability of returns, low volatility and during bad times, you can always withdraw from this basket.
So we end up with higher returns, lower risk. All of the above mentioned Asset Groups are easily accessible through ETFs. Beautiful!