What is Asset Allocation?

by Wes Bridel on February 11, 2011

in Stewardship

Asset allocation and diversification.  What are they and how should you use them to steward what you’ve been given?  We began looking at the topic of diversification through asset allocation here.  In this post, we’ll begin to dig deeper…

“Give portions to seven, yes to eight,
for you do not know what disaster may come upon the land.”
(Ecclesiastes 11:2)

Long ago, Solomon understood diversification.  You should too!  Diversification is the main principle of asset allocation.  This means combining holdings that will react differently in particular market environments so that a strong move up or down in a market or the economy cannot destroy everything you’ve built.  Always remember to first and foremost protect what you have.

The greatest money managers of all time are fanatical about managing risk.  You should do the same.  Here’s a quote from Seth Klarman (one of the greatest investors of all time)…

Warren Buffett likes to say that the first rule of investing is “Don’t lose money,” and the second rule is, “Never forget the first rule.” I too believe that avoiding loss should be the primary goal of every investor. This does not mean that investors should never incur the risk of any loss at all. Rather “don’t lose money” means that over several years an investment portfolio should not be exposed to appreciable loss of principal.

While no one wishes to incur losses, you couldn’t prove it from an examination of the behavior of most investors and speculators. The speculative urge that lies within most of us is strong; the prospect of a free lunch can be compelling, especially when others have already seemingly partaken. It can be hard to concentrate on potential losses while others are greedily reaching for gains and your broker is on the phone offering shares in the latest “hot” initial public offering. Yet the avoidance of loss is the surest way to ensure a profitable outcome.”

In this one quote, you have two of the greatest investors of all time telling you to focus on not losing money first and foremost!  They would also tell you the best way to do that is to only buy companies which sell for a significantly undervalued priced compared to their sustainable earnings.

We’re already discussed the advantages of value investing elsewhere, but bring this quote to you know because a very important way to “not lose money” over your entire portfolio is to have different assets that behave differently in different environments.

To accomplish this, it’s important to think through all the possible economic environments which might be encountered moving forward.  As you do, think about how each asset class should respond in such an environment.  If you have assets that will respond differently, then you are diversified.

We would not take this so far as to suggest you hold assets that you are sure will fall in value.  Instead, look to build a portfolio holding as many non-correlated assets as possible that you believe are good values for you in either the short or long term.  When you can see how all these pieces will work together, you are now practicing wise asset allocation.

All investors see their favorite assets move up and down in different markets.  The two keys are to 1) understand why this is happening and know that each asset individually is something you feel good about holding onto and 2) hold a portfolio of assets which are reacting differently so that overall, your capital is protected.

This is Part 3 in a series on asset allocation and diversification.  You can follow the links to read Pt 1 or Pt 2.

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