In my previous column (“Does Asset Allocation Work?” Best Of 2008), we explored how asset allocation can eliminate much of the downside when the stock market swoons. In this column, we’ll look at how to arrive at an appropriate asset allocation.
First, let’s begin with a bit of terminology. I find it useful to characterize assets as either “growth-oriented” or “defensive,” distinguishing between the two categories primarily by how an asset is expected to generate returns for the investor.
A defensive asset is one that’s expected to generate returns primarily through cash flows—that is, rents, interest, dividends. Common examples of highly defensive assets are money market accounts, insured certificates of deposit and Treasury bills.
A growth-oriented asset is one that’s expected to generate returns primarily through appreciation. Some examples are common stocks, real estate investment trusts and emerging market stock mutual funds. In this era of rapid commodity price increases, other good examples of growth-oriented assets are gold; crude oil futures; and commodity-linked, exchange-traded funds.
The terms “growth-oriented” and “defensive” actually describe the end points of a continuum. Assets can fall anywhere along that continuum, but usually fall closer to either end rather than in the middle.
Using leverage (aka borrowed money) to purchase an asset will shift the investment toward the growth end of the continuum. If you purchase rental property with cash, and the rents you can charge exceed expenses (taxes, insurance, upkeep), your investment will produce a steady cash flow. The house may appreciate over time, but if it doesn’t, you should, with appropriate care and management, be able to rely indefinitely on the cash flow from rents. This is the mark of a defensive asset.
If, instead, you mortgage property to buy it, you must use some of the rent you charge to pay the mortgage. If the mortgage is large enough relative to the rent, the cash flow disappears. Price appreciation then becomes your only avenue for return on the investment, which makes it a growth-oriented asset.
As a rule of thumb, one should expect the proportion of defensive assets in one’s portfolio to increase as one ages. An investor’s tolerance for risk (or lack thereof), however, will have a powerful impact on proper asset allocation independent of age.
By risk tolerance, I really mean tolerance for loss. Although prices of growth-oriented assets are typically much more volatile than those of defensive assets, all but the most defensive investments have a degree of uncertainty of outcome and variability of returns. For assets whose prices are determined in daily trading, it can be extremely difficult for the loss-intolerant investor to stay the course in what would otherwise be a profitable investment when the published price has taken a big hit.
A fundamental concept of investment performance is known as “reversion to the mean,” or, as Wall Street states it, “Trees don’t grow to the sky.” If a class of investments, such as emerging market stocks, has been providing spectacular returns for a while, odds are high that those returns will regress to the mean—or fall back to earth—disappointing Johnny-come-latelies.
The same principle applies to investments whose prices have been beaten down. If the stock market heads south soon after you jump in, you have to be willing to stomach negative returns to be in the right place when the markets recover and performance regresses to the mean. Otherwise, you engage in behavior certain to result in disappointment: buying high, then selling low.
As we saw in the previous column, a portfolio 40 percent invested in growth-oriented assets (stocks) and 60 percent in defensive assets (bonds) took almost 90 percent of the sting out of the stock market downturns over the past three decades while giving up only a modest portion of overall investment returns. Investors who rely on their investment assets to generate funds to meet living expenses typically have a majority of their investment portfolios allocated to defensive assets. Younger clients accumulating assets to pay for college or future retirement typically have portfolios in which a significant majority of assets are growth-oriented.
To determine an appropriate asset allocation, I assign each of a client’s assets to one category or the other, regardless of who will be responsible for managing it. Once they’ve all been categorized as growth-oriented or defensive, we’ll know if the overall mix aligns with the client’s risk tolerance.
Adding defensive assets that behave differently from your growth-oriented assets to your investment portfolio can eliminate much of the downside, so you’ll be able to stay in the game when markets are difficult. Conversely, adding some growth-oriented assets to even the most conservative portfolios can improve returns meaningfully without adding significant overall risk.
Most investors are best served when their growth-oriented assets constitute somewhere between 30 percent (for the most conservative) and 70 percent (for the most aggressive) of their total portfolios. This simple-but-powerful asset allocation guideline can allow wise investors to derive long-term benefits from their financial assets without losing sleep at every market misstep.
