Asset Allocation: Not As Easy As 10, 30, and 60.

It’s all about asset allocation.  There are different answers for different people and different market environments.  But the thing that always fascinated me was that the asset allocation decision dwarfs the stock selection decision, yet the masses are focused on stock selection.  Guessing it may have a lot to do with the action in finding the next 10-bagger vs. a boring re-weight in the asset allocation model.

So, we have a major out of balance between the attention on stock selection vs. asset allocation.  In addition, the general lack of outright attention to possible asset allocation solutions is remarkable, especially considering how many people are speaking and publishing on the markets.  Said another way – it is a crowded field, offering little by way of asset allocation solutions.

Not Your Typical 60/30/10

We hear 60/30/10 all the time.  Most are referring to the sub-optimal stock/bond/cash portfolio allocation, but when I hear 60/30/10, I think of a great simple market analysis I learned from Dr. KC Ma, my MBA Capital Markets mentor 30 years ago.  He stated that 60% of a stock’s return is from the market, 30% from its industry, and only 10% is stock specific.  I never read his source or saw his model to support this claim, but we don’t need to.  Of course, there are so many models on Wall Street, you can get them to say and do everything and anything.  The market action supports this concept, as well as the dismal performance of active managers vs. the broader markets.  The market goes up 20% that year and everyone’s a winner.  Down 20%, and guys try to brag about being down only 17.5%.

The best part of this simple 60/30/10 analysis — it saves us time.  It allows us to focus our efforts on bigger variables when managing our portfolios.

Asset Allocation

The much more import decision is asset allocation.  Deciding whether you want a portfolio of 20% stocks or 70% stocks is a bit more meaningful than where you should invest your next 2%.  And it’s fascinating how little time is spent on this topic on a relative basis, especially now that we have so many investment alternatives around the globe.

To get started, I will layout a simple favorite asset allocation here:

20% EQUITIES – Feel free to play the stock selection game, or choose an index fund that will cost you less than 20 basis points.  Or if you find a manager you like, you can package this with the fixed income allocation, and let them manage this 40% stock + bond component.

20% FIXED INCOME / DISTRESSED BONDS – The reason I mention distressed bonds is because my favorite research firm (and one of the largest independent research firms globally), Stansberry Associates, has launched a dedicated service for handicapping distressed bonds.  The argument, the education, and timing are very sound and world class.

20% REAL ASSETS – This can be real estate or hard/tangible assets.

10% PRECIOUS METALS – Many ways to play this, and there is a large difference between the lower volatility of gold vs. the mining stocks that are 5x as volatile.

30% CASH – A heavy cash component serves two major purposes: flexibility and a hedge against deflation.

**  KEY CONCEPT: THIS IS ONE MAN’S OPINION, AND THE BEST INVESTMENT YOU CAN MAKE IS IN YOUR OWN EDUCATION.

We know there is no right answer for all, and there are always exceptions and tweaks to every model.  But here we get a sense of a few basic concepts.  This portfolio looks a lot different than the typical output of the financial planner/asset gatherer.

A simple metaphor for the current state of affairs of global capital markets is a massive game of tug-o-war between inflation and deflation.  We will expand on this concept later, but this is the main reason we take a barbell approach to asset allocation.  We need to protect for both potential outcomes: inflation or deflation.  The system and forces keep building, and no telling where this thing will land.

We hear it all the time: a solution to runaway inflation is hard/tangible assets.  When was the last time your financial planner talked about commodities?  30% in cash?! Are you kidding me?  You are sure to underperform the world if you do that.  Or more probable — your planner may not get paid if they put you in cash.  Meanwhile, the cash allocation is a great hedge against the deflation side of the equation.  Not to mention it gives you plenty of flexibility to trade and invest from strength.

Many will also scoff at a 10% weight towards precious metals.  The vagueness and lack of transparency in the precious metals space keeps things challenging.  It also keeps many away.  But the simple truth is gold is money.  We can talk about the relative performance of gold vs other assets and move the reference dates to suit your viewpoint, but gold offers two attractive features to earn its way into the mix.  One, is the negative (or lack of) correlation.  You’d have to look far and wide to find an asset as uncorrelated to the stock market as gold.  And secondly, gold is money and has been for 5k years.  Of course, there are many ways to invest in precious metals, and we need to be aware that the risk characteristics of the physical metal are extremely different than those of the mining shares.

Shopping List

A simple proactive solution to managing the selection process inside each asset class is to have a shopping list.  This is a watch list of assets you want to own, but you are waiting for the right time and place to pull the trigger.  The markets change, investment targets and objectives change, and your views change.  For this reason, we need to keep an interest list and monitor it closely.  Most people have a multitude of market sources and information, and the only way to do this is to write things down and keep track of your shopping lists.

Know Your Fees

Your fees are the one thing you can control.  It is critical to know all your costs and fees at every level.  Sometimes this information is not so easy to find, and you may have to do some digging or ask some uncomfortable questions, but it is worth it.  We have all seen what a couple hundred basis points looks like extrapolated over 50 years.  Combine this with our new zero interest rate environment, and fees are everything.  And don’t forget about the cost of trading.

The two major components of trading costs are the bid-ask spread and market impact. A longer-term time horizon can certainly mitigate these trading costs, but it is all about percentages.  For example, say you are following a specific bond on your shopping list.  Suddenly, the credit rating gets cut, and the bonds are reduced to junk status.  The good news for you — your bond is down 20% overnight and you decide it is time to go shopping and buy this bond.  The bad news — this highly volatile situation (down 20% overnight) is creating a market on the bonds of 60/66 (a bid price of 60 and an offer price of 66).  Suddenly, we have a bid/ask spread of 10%.  And that is assuming you can buy all the bonds you want and/or need at 66.  Which brings us to market impact.

Due to the fascinating inverse relationship between liquidity and volatility, it turns out that not only is the new market on your bond wide, it is also thin (not that liquid).  Where previously you’d be able to fill your entire position on the offered side of the market, today you can only get half your position done at 66.  The other half is at 69.  There’s another quick 5% down the drain.

Portfolio Solutions

Status Quo

Why break what’s not broken.  There is no reason to mess with your existing allocation, especially if you are killin’ it in stocks, bonds and real estate.  In addition, you won’t have to waste any time trying to figure out what the next snowflake (to start the avalanche) may be or when it will happen.  Besides, handicapping this global macro landscape is near impossible.  All I know is nobody knows.  I understand this school of thought, and I would never argue against it.  Instead, I will lay out interesting alternatives to the status quo, or for those that think they have a hunch.

Inflation

Inflation is simply an increase in the supply of money.  Many think inflation has to do with an increase in prices, but the price increase is rather a result of an increase in the money supply.  Another way to look at inflation is the decline in purchasing power of your dollars.  The asset, whether it be your house, an antique car, or a barrel of oil is a constant.  So when we say the price of that asset increases, we are really saying the value of your currency has declined, thus it takes more dollars to buy that asset.  Therefore, in an inflationary environment, cash “under-performs”.  And in highly inflationary environment, an over-allocation to cash can prove disastrous.

Remember our tug-o-war match.  If things start shaping up to favor inflation, we need to be prepared to act.  We started with our barbell asset allocation (carrying protection against both inflation and deflation), and now we need to shift into an offense attack against inflation.  The good news — we get to go on a buying binge: spending your dollars before they evaporate.  Because things can happen quickly, and because we never know what they will look like, all we can do is take little steps to increase our chances of survival.  It is critical to have a plan.

There are a lot of little things we can do or put in place to reduce the pain of a quick and nasty inflationary shock.  For example, in our model asset allocation we are sitting on 30% cash.  It makes perfect sense to have all the wire instructions for all sources and destinations of your cash.  You can even take things a step further, and have a proactive conversation with your bank, ensuring the wire process is dialed down to its simplest form.  Know the rules of engagement to minimize every process.  It will be a lot easier to one click an email and be done with the wire, versus trying to track down wire instructions or wait in line at a bank.

Next, you need to know what you want to buy.  Well, we already have our shopping list.  Clearly, this is a new environment, and your list may have changed.  Either way, you need to spend it.  There is a very good chance we may sacrifice quality for quantity and possibly even buy stuff we do not need or want.  You can wait a day or two or three and think about it, but a brief reflection on history will show how expensive waiting can be.  This is not a time to do homework; this is a time to act.

Deflation

Deflation is the shrinking of the money supply.  The world wants to deflate.  I have heard global debt numbers as high as $300 trillion…with a “T”.  One of the contributing factors to the Great Recession was the amount of leverage/debt in the system.  The immediate response to this debt problem was…more debt.  Bailouts, backstops, and inflationary injections were used to stem the deflationary tide.  And now it requires a global coordinated inflationary effort to balance out the tug-o-war.

The world has added $60T in debt since the Great Recession.  The pressures are building, and these are unprecedented times.  This is one great experiment, and there is no telling how this plays out.  So, all we can do is attempt to prepare and tweak the odds in our favor.

Our model portfolio is already sitting on a 30% cash allocation.  Cash is king if deflation wins out.  Now we need to figure out what the world looks like and how our situation changes down 50%.  It has already happened twice this century in the US, and to think it cannot happen again in this new complex system is irresponsible.

So, back to our shopping list.  But before we do this, we should consider where we stand with respect to leverage.  Are we really a better buyer down 50%, or will the bank come calling for that pile of cash.  Either way, one would think a 30% cash allocation, combined with a 10% allocation to precious metals will be enough to take some of the sting out.

Sell Your Dollars

Everyone knows diversification is a key variable when it comes to managing risk.  We heard it in school, we hear on TV all the time, and every financial planner waves this flag.  Coincidentally, when it comes to currencies, most citizens throw this rule out the window.  In the U.S., it is safe to say that investors are overexposed to the US$.  Of course, the US$ is the world reserve currency, and has been for as long as you have been following the markets.  I would never say the dollar will lose status as the WRC, but I can tell you that the odds of this happening are not zero, and the implications IF it happens are great.  This is what tail risk is all about: the odds are so low, but the outcome is so devastating, that it warrants a little attention.

We do not know exactly what this probability is, but we do know the probability is changing…for the bad.  We can look at a whole series of data points, and they all point in the same direction.  Whether it is the new-ish agreement between China and Russia to scrap the U.S. dollar in energy transactions between the two countries (these trades used to be done in dollars and are now done in their domestic currencies), or the IMF adding the Chinese Yuan to the basket of SDR’s, or the fact that the IMF now has a detailed blueprint in place to flood the market with SDR’s in the next global crisis — all signs point to this risk increasing.

Again, there is no telling when this could happen or what it could look like, so all we can do is make some tweaks to our allocation to soften the blow.  The best strategy here is education.  Learn the topic, understand the risks, and see if you believe.  Otherwise, we can simply add some international exposure inside our allocation buckets, thus reducing currency risk.  We can also invest in foreign currencies, as currencies are an asset class.  And at the very least, we have a 10% allocation to precious metals, which should shine, if and when.  While we are on the topic of tail management, another interesting simple solution is supplies.

Supplies!

What a great idea!  Let’s buy stuff we can use!  How about food and water!  At this point, it is no secret that a little extra food and water in the house is a smart move.  I would put this in the category of “free insurance”.  As we are all forced to buy house and car insurance, and watch our medical insurance balloon year after year, and contemplate life insurance, how about a little free insurance.  Anyone care here?  You are going use this stuff anyway.  Why not have piles of it!?  There is an endless amount of supplies you can put in this category of free insurance: batteries, paper products, trash bags, propane/charcoal/lighter fluid…the possibilities are vast.  And if you want to get aggressive and take this insurance policy up from free to cheap, the list gets exponentially longer: tools, candles, toiletries, an enhanced first aid kit, etc….

Of course, we can kick things into high gear by learning some basic yet important life skills and strategies.  Don’t you think it would be smart to learn how to turn off the main gas and water line to your house?  Or how about having a handy list of all the important phone numbers, bank accounts, and passwords in an easy to access protected spot.  What’s wrong with splurging an extra $29 on a extra fire extinguisher and maybe even learning the proper technique.  And we have had a lot of fun teaching the kids how to safely use a jack-knife and how to pick a lock.  Let’s make this fun!

Conclusion

We always have choices.  The information age and new access to a plethora of assets across the globe and lower expected returns has only made our choices tougher.  At the same time, the level of risk continues to grow, as our complex systems only seem to be getting bigger.

We will never be able to guess the future, but we can certainly study some possible outcomes and make some proactive adjustments to help our chances.  You can ignore the risks, or you can embrace the process, and your best returns will always be in your education.

 

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