Saturday, December 4, 2010

Investing PART 1: Background music

Asset allocation

Previous postings have advocated diversification across asset types. It isn't hard to see that diversification will increase returns for any given level of risk (when risk is defined as volatility in the value of the portfolio). But, for sure, it reduces the chance of (or potential size of) big returns. So, allocation makes sense for most of us. We may not have a crystal ball to see the future and aren’t gambling. But, allocation should be across all assets one want to own (house, durable goods, education) not just financial assets. But, don’t get silly and start pretending consumption is investment.

Don’t forget to include any defined benefits pension and expected Social Security payments into your thinking. If you can’t figure out how to wrap your head around mixing cash streams (pension, SS) and financial assets, go to ( and get a rough estimate of the present value (i.e., cost) of a similar cash stream. Think of it as an asset class of its own or plug it in as a bond substitute. Or, do the easiest thing: figure you’ll need SS and any pension, a home, and savings in order to retire. Then ignore SS and the pension and focus on your saving until you’re near retirement. That’s a form of diversification across time, a concept we all practice almost automatically, but seldom think about.

If diversification across time seems too abstract, ask whether you’ve ever thought, “That’s a problem for another day” or “I’ve got to focus on the here and now.” Once one stops letting diversification across time just happen and instead explicitly thinks about it and incorporates it into plans, new opportunities become relevant. Further, by ignoring SS and any pension, you’re focusing on what you can actually control. Ignoring things you can control isn’t always a good idea, but in this case it works.

Diversification across time was mentioned in connection with liquidity. Once you start thinking about diversification across time, liquidity falls into place and becomes far less important than many people make it. It also drives home the importance of retirement planning. If you have to plan for both today and tomorrow each time you plan, you can’t just delay it until it’s too late.

What most people think about when, and if, they think about diversification is alternative investments (commodities, real estate, and non-public businesses), stocks, and bonds. Diversification was already discussed in connection with the postings on “Angel, Entrepreneur, and diversification,” especially in “PART 2” and “PART 3.” The focus of those posting was non-public businesses. Of commodities, only gold has ever been discussed on this blog ( “Gold: Be sure you know what you’ve hedged” , “Gold again” , and “Worth repeating and, yes, gold again” ). That could be the case for a long time. Consequently, this series of postings can focus on two specific asset types. Specifically, it will focus on publicly-traded stocks and bonds.

A diversified allocation across those asset classes doesn’t ensure a positive return every year, especially when adjusted for inflation. Just in the last twenty years, there have been two or three years where every publicly-traded class of financial assets except one experienced negative returns. The one that didn’t lose money either barely kept up with inflation or didn’t keep up with inflation.

One common way of showing differences in asset class performance from year to year is a “quilt.” A quilt looks like a checkerboard on steroids. Every asset class is given a color. Little blocks are piled up from lowest return to highest, each with a different color for each asset class. The columns are years. If you want to see one, get the Charles Schwab On Investing Newsletter for June 2010.

Quilt charts are also called asset class periodic tables. You can find one at if you’ve never seen one. But, frankly, none is presented in this posting because it’s the concept that is important, not a specific example. Each example will show its own asset class breakdown. Most examples are marketing tools where the asset classes reflect the offering of the presenter. So, don’t go using a specific example as investment guidance. View them as what they are, useful background information. In other words they’re background music, not a dance tune.

The same concept can be conveyed by an asset class correlation matrix. They’re just tables showing the correlation of asset classes over some historical time period. If you’ve never seen one, try . They appear more sophisticated than a quilt, but they suffer from the same lack of agreed-upon definitions of asset classes. They also suffer from the arbitrary historical periods used to estimate the correlations. They’re probably a little less useful than a quilt. They’re just more background music.

The importance of the concept is the reason for pointing out quilt charts and correlation matrixes, but quite frankly, the best illustration I’ve ever seen took just three asset classes (i.e., US stocks, non-US stocks, US bonds) and plotted their annual return as a difference from the inflation rate. Unfortunately, I can’t provide a link since it was in a T. Rowe Price newsletter years ago.

To illustrate how a simple concept like diversification can be put to practical use, see “'Buy and Hold' Is Still a Winner” an opinion piece from the WALL STREET JOURNAL, November 18, 2010 by Burton Malkeil. I strongly recommend the article as a simple approach for those who don’t want to spend a lot of time managing their investments and don’t mine mediocre returns. I’d also recommend it to those who do spend time analyzing and managing their investments. With a little knowledge, very little in fact, one can do better than the approach shown, but ignoring the investment facts discussed in the article makes it much harder.

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