When I started in the business in 1991, one of the biggest fundamental teachings was the concept of asset allocation. Asset allocation is all about the notion that different assets classes offer returns that are not perfectly correlated, hence diversification reduces the overall risk in terms of the variability of returns for a given level of expected return. (www.wikipedia.com)
Today’s world of asset allocation uses these fancy pie charts that show clients cash, corporate bonds, international bonds, government bonds, large cap stock, mid cap stock, small cap stock, international stock, emerging markets, commodities, real estate, and many more different types of asset classes. The idea of all of these asset classes are supposed to act and look a lot like magnets. By having a balance of these asset classes, while some areas have worse years other categories will have better years, minimizing the overall risk.
The world’s global economy is so intertwined that many asset classes are more closely tied together. Look at this snapshot from Morningstar showing the 1 year fiscal returns on asset categories across the board (as of 1/22/2016).
|Large Cap Blend||-8.10%|
|Mid Cap Blend||-12.16%|
|Small Cap Blend||-12.68%|
|Long Government Bond||-2.22%|
|Short Term Bond||-0.14%|
In the Morningstar 1 year trailing numbers, the only category that fared well across the board were municipal bonds. Would you have been prepared to move all of your money into municipal bonds one year ago if your advisor told you this would be the best idea for your money? Where would you have invested in your 401(k) which don’t even have municipal bonds as an option? I believe the way you think about asset allocation needs to change because the traditional world of asset allocation will not work the way it did in the past due our global economy works so closely together these days. Here are my three buckets of asset allocation.
- S- SECURITY- The first area of your asset allocation is determined by how much money you need to keep in the security bucket. In the good old days, the secure bucket was largely determined by what the corporation would provide you for a pension when you retired. As many of us realize today, companies hardly offer that type of benefit anymore. Consequently, you need to put some of your money in products or vehicles that guarantee your income down the road. These are typically done with insurance companies and you can do this while still controlling the direction of your cash.
- I- INCOME- The second area of your asset allocation is going to be determined by how much money you need to keep in the income bucket. There are various type of income producing assets, some fixed and some variable. In the fixed income arena, we are talking about preferred stock, business development corporations, municipal bonds, U.S. Government bonds, corporate Bonds, rental real estate, lending club, etc. This isn’t an end all and be all list, but what you are attempting is to get some investment class that will kick off yield and where there may be the potential for growth. There are lots of different alternatives in this category.
- G- GROWTH- The third area of your asset allocation is going to be determined by how much money you need to keep in the growth bucket. The growth bucket is designed for ownership type dollars. Specifically, having money in assets such as stocks, precious metals, your primary residence, and other categories where you are putting dollars at risk for the potential for larger future growth. These are long term hold investments. Growth investing can happen in all types of accounts including 401k’s, IRA’s, Roth IRA’s, and brokerage accounts. Within this category you may need to become more active than you did in the past to look for the opportunities that are beaten up to earn significant upside return.
Will traditional asset allocation work?
Time will tell, but here is a different take on how to do asset allocation in the future.
Using asset allocation and diversification as part of your investment strategy neither assures nor guarantees better performance and cannot protect against loss of principal due to changing market conditions.
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Ted Jenkin is a frequent guest columnist for the Wall Street Journal and Headline News Weekend Express. He is the co-CEO of oXYGen Financial. You can follow him on LinkedIn @ www.linkedin.com/in/theceoadvisor or on Twitter @tedjenkin.