Saturday, May 30, 2009

How Should Households Invest? Sharing My Asset Allocation

Investing without an asset allocation in mind is more likely gambling than actual investing

A sound asset allocation is a key component in any investment portfolio. To put it bluntly investing without an asset allocation in mind is more likely gambling than actual investing.

Two weeks ago I wrote about my decision to gradually increase my exposure to the stock market as the low interest rate levels make it impossible to generate any real return on investment. Some may say low interest rates are a poor advisor. Still, I am quite confident in my decision to increase exposure to stocks in the long term using dollar cost averaging.

Having made up my mind on the question of when I turned to the question of what should I invest in or in other words: what would be a good asset allocation for me?

Asset allocation actually answers the very basic question of investing: What is the return I expect on my investment and, hand in hand, what is the risk I am willing to take?

A short introduction to asset allocation

I feel a short introduction is in order for those less familiar with the concept of asset allocation. I will avoid a deeper methodological discussion at this time.

Asset allocation is the strategy chosen by an investor to distribute his or her investment portfolio among various financial assets to achieve the investment goals. Asset allocation is the corner stone to investing.

Asset allocation has several goals the most important of which is to express the risk appetite of the investor in terms of allocation of funds to different financial assets through which the investment will achieve its goal taking into account the risk involved.

In finance theory, asset allocation is a means of minimizing the specific risk a certain financial asset has. Since various financial assets are not perfectly correlated diversification of the portfolio to several financial assets may (and perhaps should) result in a portfolio which is complete diversified with as little specific risk as possible (specific risk is the risk a certain stock has such as the death of a successful CEO). The diversified portfolio remains with the market risk only – the risk that characterizes the entire market.

Assets may and should be allocated according to several parameters for adequate diversification:

  • The level of risk of the financial asset – From derivatives to government bonds financial assets holds varying levels of risk. Through asset allocation one risky instrument may offset another.

  • Specific characteristics of the financial asset (usually associated with risk) – Stocks of different types vary immensely in risk and return. Large-caps are usually considered more conservative while small-cap or emerging markets are traditionally considered riskier. Risk levels in bonds vary as well with government bonds on the safer side (depends on government of course) and high-yield junk bonds are sometimes riskier than stocks.

  • Foreign currencies – Allocation across currencies is important as well to reduce exposure to a single currency and increase exposure to other powerful or promising currencies.

  • Other parameters such as industries, geographies, commodities, real estate and more.
    Asset allocation holds infinite possibilities. The guideline, as I mentioned, should be the risk appetite of the investor.

My asset allocation

If you've read my previous post on my decision to return to stocks you are aware of my choice to invest through ETF's and index funds. I believe that household investors with as little time on their hands to manage investments should not try to identify value investments in stocks simply because we don't have the time.

Chances of beating the market are slim to none so my recommendation to household investors, such as myself is to join the market (other than try and beat it).

Thus the allocation I will present will be achieved through investing in ETF's and index funds which track a certain index which suits my desired allocation.

It is important to remember that the following allocation is one I built for my own risk appetite and financial situation. Is may serve as an example but should be adapted for anyone else. The purpose of this post is to share my investment management with my readers.

The following is the asset allocation I have chosen for my investment portfolio:

I plan on reaching this asset allocation within 6 months of gradually increasing my exposure to ETF's and index funds in each category.

My considerations for choosing this asset allocation

My considerations for allocating my assets as such are comprised of the following:

I believe the US will emerge first from the current crisis with Europe lagging behind. I believe that the US economy is much more flexible and open to allow for rapid return to growth. The European economy is heavier and less flexible and will suffer more through the coming period. The level of money printed by the US government and the low interest rate environment are frightening as inflation my quickly be upon us. Still, I believe the US economy is resilient enough to withstand such impacts. Hopefully the situation would allow for rapid correction of interest rates to combat inflation after growth has been achieved.

Emerging markets present a long term opportunity which I would hate to miss. This is quite a risky investment but for the longer term (over 15 years) emerging markets such as China, India and others look very promising.

The financial sectors should rebound first if it survives. Banks are usually the first to capitalize on return to growth through credit issued and investments made.

As I mentioned I don't believe in beating the markets so I've decided to join them by investing the rest in ETF's and index funds which track country leading indices such as the S&P500, FTSE, DAX and others.

Monitoring my asset allocation

Setting up an asset allocation is not enough. As values of assets change the allocation shifts. Imagine a strong bullish period in stock markets. The percentage of investment in stock increases as stocks rise thus slowly shifting your asset allocation towards this instrument.
I've written a post in the past on how to monitor a portfolio which I strongly recommend as a supplement to this post.

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Michael Harr @ Wealth...Uncomplicated said...

I take it you are a conservative investor. These allocations are definitely on the conservative side considering your long time horizon. I've really liked corporate bonds since Q4 of 2008 as many have been beaten down unfairly. As for the financial sector, much remains to be seen. I am hoping for a repeal of many of the provisions of GLBA and a tightening of capital requirements and oversight of derivatives. If that happens, the financial sector should get back to a more normal representation of GDP meaning growth rates of financials will certainly be curbed.

QUESTRADE COUPONS - All Coupons, discounts, promo codes, offers, and reviews said...

This should be a mandatory read. For me i never gave much attention to "asset allocation" and lost a bundle because i kept investing by following the returns or even going by other people's advice without my own research. It's funny how rarely that works. Proper asset allocation based on ones risk assessment is the way to go to true weath. Ive learned my lesson

active said...
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Dorian Wales said...

@Michael Harr - Quite conservative indeed. I might increase exposure but I like to wait for more market evidence.

@Questrade - we all learn the hardway I think... Funny thing is no one actually learns from investment mistakes of others. Everyone has to pay tuition first...