An Allocation Method For Managing Total Assets

 |  Includes: SCHB
by: Total Return Investor


Asset allocations based on percentages do not work well for managing total assets.

To remedy this problem I construct an alternative approach for allocations of total assets.

The alternative treats asset classes as ingredients for constructing an investment account and a short term account.

There is a dearth of systems for prudently managing ALL one's assets, including assets set aside for short term needs. Yet this is an important topic. Get too conservative and long term growth stagnates; get too aggressive and you risk leaving yourself permanently worse off, especially if your time horizon is not long enough to allow recovery from serious errors.

One word of clarification--the title is a bit misleading. I have nothing to say regarding one's house, cars, or any other assets that are not normally in play for financial maneuvering. While I am sure there are people who would take out a second mortgage or sell a car in order to raise investing capital, I'm not one of them. Our house is for living in and our vehicles for driving.

Background and goals. Since managing personal finances is not a one-size-fits-all activity, let me provide relevant background information. My wife and I are retirees in our late 60s in moderately good health. Realistically, our time horizon is around 20 years. At the present time we have no debt and no one is financially dependent upon us. We have a modest nest egg that provides grist for the investing mill, but not one that is large enough to yield significant cash flow from dividends. Fortunately, we do not need a revenue stream from dividends because pensions plus Social Security are sufficient for us to live comfortably. Whether this will continue to be so in the future depends on inflation, and of course that is something no one can know.

Given these circumstances, our investing goal is to prudently grow our assets so that, whatever inflation does, we can continue to enjoy some of life's amenities and still leave a nest egg to our heirs. A secondary consideration is to have an overall approach that is simple enough so that my wife could take it over without undue difficulty should I die or become incapacitated. Like many spouses, she is not captivated by the finer details of investing.

The problem. Most investors need to satisfy two goals. The first and more important goal is to pay for predictable short term needs and to provide a cushion against possibly severe but unpredictable expenses. The second goal is to grow assets for the longer term. The financial vehicles for meeting these goals pull in opposite directions. Liquidity to satisfy short term needs does nothing for long term growth, and vice versa.

Asset allocation schemes that work only in terms of percentages do not do a good job of tackling both these goals. For example, Warren Buffett recently stated that upon his death his widow should keep 90% in a broad index equity fund and 10% in short term Treasuries. I'm sure this allocation would suit Mrs. Buffett's situation nicely. A mere 10% of hundreds of millions still leaves plenty of room to deal with an emergency. But it would be insanity for most families. My wife and I would be dangerously exposed to the whims of the market if we set aside only 10% for short term needs. Absent specific information about the size of the total assets, it is useless to draw up general schemes that prescribe allocations only in terms of percentages.

The solution. My alternative approach uses three asset classes: equities for growth, cash for liquidity, and "near cash" as a hybrid class pursuing both growth and liquidity. By "near cash" I mean things like bonds, preferred stocks, and CDs--things that usually provide some return, are generally less volatile than equities, and are usually not closely correlated with equities.

What about precious metals? If pushed, I guess I would classify them as "near cash" but the plain fact is they defy classification. Because they are not closely correlated with equities, they are often available without significant loss if one needs to raise cash during an equity slump. But there is no guarantee of this, and they can be quite volatile. They march to a different drummer, and that is reason enough to keep their role very small to nonexistent in a well designed portfolio.

I use these three asset classes to construct two accounts: an investing account, and a short term account. All the equities and all the near cash reside in the investing account. All the ready cash and all the near cash reside in the short term account. So I solve the problem of how to deal with near cash simply by assigning it fully to both accounts.

But how is this possible without wandering into Madoff territory? There is no problem if the different accounts use different units of measurement. The investment account speaks in terms of percentages, and the short term account in terms of dollars. Put slightly differently, the investing account consists of, say, 65% equities, 35% near cash, and 0% cash. The short term account consists of, say, $10,000 cash, $50,000 near cash, and $0 equities. There is no clash in thinking of the near cash as 35% of the one account and $50,000 of the other. (The numbers here are for illustration only. I will discuss how I determine my numbers below.)

This is as it should be. What matters for purposes of securing short term needs is the number of dollars at one's disposal. In contrast, for purposes of efficiently pursuing long term asset growth what matters are percentages. There is a considerable body of evidence regarding how well different asset percentage assignments function in growing assets, and we need to be able to put this evidence to use.

Applying this approach. Even given the same financial circumstances, different persons will have significantly different opinions on the numbers that should be plugged in when applying this approach, given their differing aversions to risk. I will explain my thinking on this, acknowledging that others may see things very differently.

1) Since providing for daily needs must always come first, I tend to the short term account first. I do this each month by first rebalancing the ready cash (checking and brokerage sweeps fund) to total three times our average monthly expenses. This may seem like a lot of cash, but my wife and I are at the point in our lives where we are tired of counting the pennies on routine things. (At least I am. She still loves clipping coupons!) And it is not as if we are missing out on large sums by not investing every available short term penny in bonds or CDs.

2) I think it is prudent for the total of our short term account to equal a year's average annual income. Since our annual income is quite dependable and our annual expenses fairly stable, an extra year's worth of funds in reserve gives us at least a two year cushion to fall back on before we would have to sell equities should something go seriously wrong. I have already covered a part of this amount with the monthly ready cash, so next I simply check to insure there are enough additional dollars in near cash to add up to a year's income.

3) Finally, I move from the short term to the investment account. Now I begin thinking in terms of percentages rather than dollars. My hope is that the investing account will grow and be passed on to our heirs largely intact. If the short term account is doing its job, the only reasons for selling any of the equities should be to dispose of a company that has changed fundamentally for the worse, to buy a still more appealing company, or to rebalance the account. Or I guess possibly to raise money to make a truly major purchase, such as a new house. But at our stage of life, really major purchases are not likely.

So why even have a certain percentage of near cash in the investment account? Why not go 100% equities? Because beyond a certain point, the return to be gained by increasing the equity allocation begins to flatten while the increase in risk does not. Given the safeguards provided by the short term account, I may not need additional protection, but when the risk to reward factor is empirically knowable why not utilize it?

According to charts provided by Schwab, over the last 43 years a mix of 60% equities and 40% bonds/cash has returned an average of 9.8% with a swing of 51.8% between the best and worst years. Boost the allocation to 80/20% and the return improves to 10.2% while the swing increases to 63.9%. Boosting it again to 95/5% improves the return only to 10.4% while the swing between best and worst years increases to 75.9%. Note that the volatility is increasing in a fairly straight line but the return is not. There is a risk/return sweet spot here, which I judge to be in the vicinity of 75-80% equities and 20-25% near cash. Again, I am now thinking strictly for investment purposes. Since the short term account has my rear protected, those are the only terms I need to think in.

I am working to get the equity portion of our overall assets to within this range, but it is a work in progress. I cannot do it in one swoop because the requirements of the short term account always take priority.

I do not try to time the market. All equity dividends are DRIPped wherever possible. Whenever there is equity money available it is invested in equities straightaway. While my preference is to put such money into best in class companies selling at a fair price or better, sometimes I cannot find any of these companies. In that case I park it in the Schwab Broad Index Fund (NYSEARCA:SCHB) , which I can trade commission free. This ETF functions as a slush fund so that equity money does not gather dust while awaiting an appealing individual pick.

The downside of this approach is that I will have no significant amount of dry powder available to pounce when the market corrects, as it eventually will. That is a downside I can live with, because study after study has shown that in the long term it is time in the market, not timing the market, that succeeds.

Conclusion. All in all, I have been pleased with the returns and peace of mind which this approach provides. My wife understands the basic structure even if she has no interest in tinkering with the minutiae of the equity category. I have advised her that if she should have to take things over, she should retain this basic structure but replace the current equity holdings (approximately 20) with just one--SCHB or some other broad index ETF.

Thank you for reading, and I welcome your comments.

Disclosure: The author is long SCHB.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.