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Asset Allocation

March 22, 2007 by  


By Bob Wood, Muslim Media News Service (MMNS)

Readers of this space may feel at odds with what I’ve written before about the value of more traditional investing methods like asset allocation and diversification. I am as sure as I can be that those traditional concepts offer little value to investors in the markets. I even added recent comments by Warren Buffett that agree with my position. But in simple terms, all investors will end up allocating their financial assets somewhere. Let’s look at some alternative methods to the conventional wisdom used by the vast majority of investors, both individual and professionals alike.

When I say asset allocation and diversification do not work, what I refer to are the methods alluded to by Mr. Buffett, the methods taught in business schools and to anyone trying to educate themselves on how to build/manage investment portfolios. Any of you can surely buy books or go online and read up on the most agreed upon methods for allocating your savings.

In short, dividing your savings between several asset classes like domestic large cap stocks or mutual funds, often referred to as your “core holdings,” and then adding shares of mid cap and small cap stocks, is recommended. Smaller amounts are to be invested in international markets and, for less aggressive investors, allocations in fixed income or bonds are to be added. A broader mix would include real estate and precious metals.

And in a long-running bull market, this kind of allocation set should work okay, with the added benefit of reducing volatility and giving you exposure to better performing sectors like those small caps and international stocks or funds.

My main problem with this kind of allocation is that while it should work well in a bull market, what doesn’t? Wouldn’t an investor do much better in a bull market simply by investing in those more aggressive options like small caps and international stocks?

Here’s an even bigger problem with the traditional allocation set. While it should work well enough in good times, how would it normally do in down markets, like the bear market cycle we all endured in the early years of this decade? Were investors with varied equity funds well served by their diversification efforts, when all of the major indices were falling in tandem?

So, just as there are better ways to go in bull market cycles, there are also better alternative methods to consider during bear market cycles. Of course, the most vocal objections are that nobody can be certain if we are in an enduring bull, or bear market.

I think that is among the weakest arguments to make in opposition to my premise. Anyone investing according to traditional methods like asset allocation are betting that stocks will rise, and are assuming bull market conditions, aren’t they? What makes this the default assumption for so many investors?

The first assumption we will all make is whether to be bullish or bearish, and all investors make one choice or the other.

But there are good ways to predict the future market direction, whether bull or bear. Here is the concept, which I learned years ago. Bull markets of the enduring, secular kind always begin when valuations are low and interest rates are high. Bear markets begin when valuations are high and rates are low.

And which do you see now? Interest rates are coming off the all time bottom, at least in my lifetime, and ten-year Treasuries yield 4.55%. The S&P 500 sells at about 17 times earnings, with the Value Line index, a broader measure selling at 19 times earnings. So all of these major asset classes are offering first year earnings yields of 5-6%.

Those returns are historically low.

So if you buy my premise that bonds and stocks are both selling at premium prices, a common event at bull market peaks in the past, what good will traditional asset allocation methods offer?

One option is for you to sell everything and sit in cash. But investors seem to be hard-wired into thinking that they must always be involved in the markets and just can’t seem to get themselves to sit on the sidelines for very long. And any run-up in stocks, no matter how brief, sends then scampering back in so as not to miss the latest rally. That the illustrious Mr. Buffett still sits on almost $40 billion in cash doesn’t seem to influence us.

My personal feeling is that there is always a bull market somewhere, and while I have avoided the domestic markets for the past few years, I have enjoyed stronger markets in other places, and in asset classes like gold. But now, even foreign stock markets are beginning to look suspect.

In this space in mid-February I advised that those of you who had holdings in emerging markets might want to scale out and hold some cash. More recently, legendary investors Jim Rogers and Marc Faber have also warned of potentially rocky times in those markets.

That seems to leave precious little opportunity for those of us hoping to remain fully invested. Or does it?

The expectation that I live with is that if there are any investing options that may well provide solid returns regardless of the investing environment, it is my job to find them and include them in my portfolios. And if stocks are expected to lose ground, there are certainly investing methods or vehicles that are designed to take advantage of this opportunity. These days, it seems that there are mutual funds and exchange traded funds for all seasons and purposes.

For most of you, sitting in cash like Mr. Buffett does is certainly your best and safest option. For those of you with a more aggressive attitude and no philosophical aversion to methods like short selling, there are plenty of ways to work that strategy into your portfolio. It is one thing to sit in cash and not lose money, but some of us would like to make a fair profit in a falling market.

Should you believe as I do that the domestic markets are in danger of falling in the near term, or the longer term too, then there are mutual fund options built for you. I have covered the topic of bear market funds before. And now there are mutual fund options for those who want to hold on to their favorite international and emerging markets stocks as I do now.

I can’t get used to the idea that selling stocks like RIO, CRESY, KHDH, PBR or others I hold won’t come back to bite me in the future. I really think that they will be selling at far higher prices in the years to come. But the volatility in emerging markets stocks and funds could cause severe short term discomfort.

My version of how asset allocation should be done in today’s market climate means that the inclusion of funds that short the international and emerging markets should be used. I consider these to be methods of insuring my accounts against those forecasts of the legendary investors mentioned above coming to be. Fund families like Rydex and ProFunds offer choices here.

Heavy does of international bonds should also be considered as insurance of a kind against what is certainly a dangerous time for the value of the dollar. And energy funds offer excellent inflation protection while being diversified enough to help mitigate volatility. Commodity and precious metals funds add exposure to a sector that is traditionally non-correlated to the domestic stock market, meaning that they can be expected to weather downturns in stocks and offer upside potential.

I hope that by now you have noticed the defensive nature of my current allocations. This to me represents asset allocation that is fluid and adjustable to different market environments than the perpetually bullish times that traditional asset allocation methods assume will forever continue.

I have always been amazed that those advocating traditional asset allocation methods never seem to offer ways to adapt in changing economic and market climates. To blindly assume that the economy will forever grow despite the clear signs of a secular shift in economic dynamics favoring foreign economies seems to be missing the proverbial 800 pound gorilla in the room.

As Bob Dylan sang years ago, ‘’the times they are a changin’’’, and for investors, the times are changing in structural, secular ways. To stubbornly adhere to a method for investing that worked when things were much different, a time when manufacturing and exporting was the driver of our economy and international investing options were few and far between seems a recipe for losing money steadily.

You can build and manage a portfolio of stocks or mutual funds according to asset allocation principles, adjusting for changing economic times. But it would be a lot better to abandon recipes that assure mediocrity at best. Do as the great investors do. Look for the best places and things to invest in, load up and be patient.

Have a great week.
Bob

Bob Wood ChFC, CLU Yusuf Kadiwala. Registered Investment Advisors, KMA, Inc., invest@muslimobserver.com.
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