How do you Use Asset Allocation?

by Wes Bridel on January 12, 2011

in Stewardship

Asset allocation is crucial as we said last week.  However, we want to immediately challenge modern asset allocation theory.

“You prepare a table before me in the presence of my enemies.  You anoint my head with oil; my cup overflows.  Surely goodness and love will follow me all the days of my life, and I will dwell in the house of the LORD forever.” (Psalm 23:5-6)

Modern asset allocation theory (or Modern Portfolio Theory as it is called) is based upon the idea of an “Efficient Frontier”.  This was developed by Harry Markowitz in the 1950’s.  The idea behind it is that by holding a variety of non-correlated assets, you can reduce your risk and increase your return.  From this high level understanding, it is absolutely correct.  However, the ways in which it is used are much more suspect.

There are a variety of ways in which this asset allocation theory is applied.  There are very sophisticated computer models that can help you determine the exact percentages of each asset class which will give you the highest return for the level of risk (standard deviation) which you are willing to accept.  In other words, figure out how much loss you are willing to take in the short run, and then pick the percentages of each asset class that the computer model tells you to pick and you will have the highest possible return for your level of risk over the long term.

The funny thing is that all the different computer models give you different answers depending on how the formula for each was calculated.  If there was a scientific way to reach optimum performance given a level of risk, wouldn’t all the models give you the same answer?

Even more peculiar is that most of these programs change the percentages in which you should allocate to certain asset classes each year given the new year’s additional data.  Again we ask, “If you’ve got the ideal asset allocation, then why is the ideal going to change next year?”

You see, there are major problems with this “scientific” approach!

However, the biggest problem that we see is altogether different than the above.  These formulas don’t account for what could be the biggest game changer of our lifetimes in any way whatsoever!  They completely ignore this problem and open up the potential that those wishing to take on the least risk will actually lose the most.  To explain, we’ll give you the most simple and common asset allocation formula out there.

A common formula for determining asset allocation is to divide your assets between equities (stocks) and bonds based upon your age.  Whatever age you are, you select that percentage of your assets to be bonds.  The rest (up to 100) should be stocks.

So if you’re 40 years old, you should have 40% Bonds and 60% stocks according to this model.  If you are 70, you should have 70% bonds and 30% stocks.  See how this works?

This model is based upon the idea that bonds are more conservative and safer holdings than stocks.  You don’t expect to make as much money in bonds over the long haul, but you also don’t have to worry as much about losing your capital.  In other words, they are less volatile.

This has been more or less true throughout the history of our country.  It’s perhaps obvious that Modern Portfolio Theory was developed with modern times in mind.  And of course, Modern Portfolio Theory really only focuses on our own experience while discounting what the “First World” considers to be “Third World” countries.

But what if the markets of the world decide that they are no longer willing to let the United States run unprecedented debt and deficits?  What if the value of the US Dollar drops in a very substantial way?  In this case, stocks could theoretically eventually recover, but the value of bonds never would.  This is because they are a promise of payment of a fixed number of dollars in the future.  If the value of those dollars is significantly reduced, bonds end up being extremely risky!

The whole portfolio theory goes out the widow because it was based on the idea that the history of the last few decades will repeat indefinitely and ignores the history of the last many centuries that shows that huge macroeconomic game changes happen quite frequently over millennia, but are always surprises to those living in the times themselves.

So we don’t advice you to take some simple formula that someone else has created and branded as “the best way to efficiently achieve superior results at a given level of risk.”  It could end up being hogwash.

A far wiser strategy is to have understanding of the key principle of asset allocation and then use your own understanding and discernment to develop your own allocation based upon the combination of assets which you believe will give you the best level of safety and growth opportunity.

You might believe that we are in the early stages of a long drawn out deflationary depression and thus long dated US Treasuries are a premier investment because you see the 30 year Treasury interest rate collapsing to 1 or 2% and the threat of “hyperinflation” or “US Dollar Devaluation” as insignificant.  This stance seems risky to us, but there are economists which we respect who hold this view, and this view may turn out to be the correct one.  If so, hold lots of US Treasuries by all means!

But do it because you understand why you are taking that position.  Understand why and how you might benefit and what the risks you are assuming are.  Everything has risk.  Don’t every underestimate the risk associated with any holding.  Once you understand that, you will be better prepared to apply the main principle of asset allocation.

We’ve begun a new series which will educate you on how to use asset allocation for safer and greater wealth building.  Beyond this, this stage has several examples of people with very different personalities and inclinations and shows you the style of asset allocation employed by each.

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