The simple maxim "no risk, no reward" is commonly tossed about when evaluating investments. The underlying financial theory is that there is an opportunity for increased returns by assuming greater market risk volatility. To be clear, those increased returns can be positive or negative, and that's why the investment process begins by defining the risk profile before discussing where to invest money (see my instablog).
In practical terms, there are patterns such as:
- Investors who are conservative will have fewer high risk assets than those who are aggressive. Over long horizons, one would expect the conservative investor to earn a smaller rate of return, although this is not always a true outcome.
- Goal-oriented investors will seek only the risk that is needed to meet their goal by comparing the actual funds available for saving versus their target amount. Once their saving and investing achieves a target amount, excess savings may be eligible to be placed in higher risk pursuits, but their "nest egg" or goal amount will be conservatively invested, most likely in US Treasuries (for a US investor).
- Income investors will seek periodic payments that meet their spending requirements while varying the investment risk to principal based on their ability to absorb losses. Most income investors have a modest ability for losses relative to the overall portfolio size.
The goal of investing in financial assets is to achieve financial gains, and investors will find that each advisor or brokerage firm has their own listing of potentially investable assets - the past twenty years has been witness to a proliferation of mutual fund choices and ETFs. For most investors, we will use the following broad asset classes:
- Fixed Income
- Real Estate
Generally speaking, the more sophisticated the investor, the larger the set of asset classes. For example, a higher net-worth investor may add Private Investments (e.g., Venture Capital, Hedge Funds, Private Equity) and foreign exchange or derivative overlays - these alternative asset classes will not be addressed in this article.
For the average investor, the Real Estate portion of their asset mix is probably comprised of the equity in a personal residence and/or investment property. In the event that the investor requires additional real estate exposure, there are a variety of REITs or REIT ETFs which can be used to add to the real estate portfolio. Following are a few:
- Vanguard REIT ETF (VNQ)
- iShares U.S. Real Estate ETF (IYR)
- SPDR Dow Jones Reit ETF (RWR)
- Schwab US REIT ETF (SCHH)
There are investment analysts who dedicate themselves entirely to the evaluation of REITs, and those opinions can be useful when selecting specific funds to include in the portfolio. For this paper, I will assume that Real Estate selection has been done independently, and the remaining assets to allocate are Cash, Fixed Income, Equity and Commodities. Several times I have met an investor who has been advised to lighten up on their home equity in order to take on more fixed income or equity risk. In my opinion, this is not a good idea. We have seen in times past that correlations tend to shift towards unity when there is financial distress, and watching your home go underwater while your stock portfolio falls is not a desirable outcome. With the exception of active traders, I have found that most people feel relaxed by having low leverage situations, small mortgages, and portfolios that can be adjusted periodically.
I have written in the past that I am not impressed with most commodity investment vehicles, because their legal and tax structure (partnerships) often generates K-1 income that is difficult to forecast and manage. In addition, there is some lingering risk surrounding commodity investment vehicles which initially arose when food prices spiked in early 2007-8. More can be read here .
In my opinion, investors who seek commodity exposure should limit their investment to not more than 10% of their total assets, regardless of risk profile. That's my professional opinion, and it's based on my experience in the financial markets and in dealing with commodity investments. Commodity assets can vary wildly, they can move in price rapidly, and the average investor will usually be too long, too late, losing any excess returns they may have enjoyed in prior periods. And yet, despite these drawbacks, it is important to get some exposure to the commodity assets for certain investors because it provides a complementary market risk and return component to a diversified investment account.
In the current climate, commodity investments can be limited to GLD, SLV, OIL, and DBC (or USCI). For simplicity, many investors can seek only a diversified fund like DBC or USCI, because these are broad commodity index funds that contain petro and precious metal along with agricultural staples. If one invests in either DBC or USCI, be prepared to receive a K-1 even if you sell it before year-end. More info can be found here.
Asset Allocation Mixes
The first step to filling out a target investment portfolio is to define a target asset allocation amongst the asset classes I have illustrated, with the caveat that investors with certain risk profiles will invest differently than others. Following is a model of the mapping of risk profile to asset class mixes:
Ed's Asset Allocation Guide 2014
|Profile / Asset||Conservative||Aggressive||Income|
- 6 month emergency fund is EXCLUDED from the above table
- Primary residence is excluded
- "Goal" accounts are excluded from this table
- Temporary cash balances may arise in an aggressive investor's account, but they will be redeployed.
- "Cash" in the above table means money market or similar investments. It assumes the investor has other cash accounts for living expenses in a checking account, and such balances are excluded from the analysis.
The above ratios are my preferred mix for 2014. They may change slightly year-to-year based on expectations for future market returns, but more often the mix of assets inside of these classes will change based on my investment thesis. For example, the detailed implementation of the above mix will illustrate my bias towards short-term fixed income, domestic small cap equity (despite the recent run-up), and metals.
Implementing the Asset Allocation
The definition of the risk profile and the suggested asset allocation are important precursors to selecting specific assets to implement a target asset allocation. And once the correct mix has been chosen, the next step is to implement the target. The implementation of an asset allocation is one of the places where a truly attentive asset manager can add significant value.
Market Rate of Return
An investor can closely mirror the market rate of return by remaining passively invested in a set of ETFs which are based on indexes of assets, as illustrated below:
Money Market, CDs, Savings Accounts
- Above is based on US investor perspective! International investors will have different base indexes
- Actual ETFs can be replaced by Broker-specific funds (e.g., Schwab has a full suite of in-house ETFs and preferred funds listed in their OneSource Select List. Other brokerages have similar models.)
I have set the weightings within each asset class based on my view of prospective returns and volatility for the upcoming year. The specific biases that I have chosen are being overweight in short-term fixed income and small-cap US equity. In addition, I have overweighted precious metals in the commodity portfolio. And yes, I know metals have been losers in 2013 and are unloved by most analysts right now.
With the above table, we can implement an asset allocation by using a simple spreadsheet. In the table that follows, one can view the cross-tabulation of the asset allocation translated into specific ETFs. Note that goal-oriented accounts require specific analysis to quantify the time horizon of each goal, along with the periodic investments. For that reason, the goal-oriented mix is not included in the table. I recommend that investors with specific time and/or quantity goals should consult with a financial advisor for a personalized recommendation.
Following are some informal performance calculations to provide a guideline for how the above mixes would have performed over the past time horizons. Note that I had to estimate certain areas, and this should only be interpreted as a high-level indicator of the range of historical performance.
|Category||1 yr %||3 yr %||5 yr %||10 yr %|
The principal judgments that have been made thus far in the asset allocation have been geared towards creating a portfolio that can be compared to a composite index of passive investments. With any of the portfolios above, the individual investor's performance would closely match that of a benchmark of global stocks, bonds and commodities. And while there could have been adjusting of the actual assets (e.g., more SPY and less EFA), the overall decision making has been geared towards getting a passive, index-based return. I indicated earlier that the implementation of the asset allocation is that place where a truly attentive asset manager can add significant value, and the above listings should be considered a guide, not a stock recommendation.
In addition to providing a customized asset allocation that is tailored to an investor's profile, the investment manager can add value by seeking performance superior to the passive, index-based returns. The performance return in excess of the general market return is called "alpha," and it is based on the following equation:
α = Rp - [Rf + (Rm - Rf) β]
- Rp = Realized return of portfolio
- Rm = Market return
- Rf = risk-free rate
- For more, see here
Alpha can be interpreted as the "value-add" from the investment manager, and I will discuss several investment decisions which can be applied to the investment portfolio and can provide alpha. Also, it should be noted that alpha can be negative as well as positive. Negative alpha is the loss of return that an investor misses out on due to investment decision-making that causes the portfolio to diverge from the stated benchmark - sometimes this is called tracking error, but I think negative alpha is more descriptive for cases where an investment decision has damaged performance relative to the index. Because of the value of compounding returns, consistently positive alpha can make a significant improvement for an investor's experience, and hence it is a highly-sought after characteristic. The principal areas of seeking alpha that I will delve into in subsequent articles are as follows:
- Tactical Asset Allocation
- Fundamental Strategies
- Option-based overlays
This list is not exhaustive, but I believe it will cover a sufficient array of investing strategies and will provide sufficient detail to foster a greater level of financial literacy and sophistication for the reader and investor.
Additional disclosure: Investing can involve loss of principal. This paper is educational, and is not a recommendation to buy/sell any specific stock.