First, let’s get one thing out of the way right up front – there are never any guarantees when it comes to investing. That said, there are some techniques and approaches that have worked extremely well over time and are widely accepted as critical to successful investing. One of these is the concept of asset allocation.
Now while it is no guarantee, when there is something that your Grandma told you about time and time again, it is a pretty good bet that you should be paying attention. Your Grandma did not teach you about asset allocation? Actually, she did, when she told you:

• Never put all of your eggs in one basket

That simple, well-known adage is EXACTLY what we are talking about when we speak of asset allocation.
While many people have heard about this concept, most do not appreciate its power and do not follow it in practice. I’m going to go through what asset allocation is, why it is important, and explain how you should implement it in practice.

Asset Allocation Explained

Asset allocation refers to the systematic use of multiple asset classes in constructing an investment portfolio. While it sounds complicated it is actually quite straightforward. When you look at the business world you see a number of different characteristics of the companies. There are big companies (large capitalization stocks) and small (small capitalization companies). There are companies that are in the United States, there are also companies that are located elsewhere (international companies). Some companies are located in parts of the world that are earlier in their development economically (emerging market stocks). There is the option to own a company (stocks) or loan money to a company (bonds). There is the opportunity to loan money to companies for the short term (short-term bonds) or the long term (long-term bonds). There is the option to loan money to a company (corporate bonds) or a government (government bonds). Asset allocation is the process of deciding which of these things you want to do AND committing to that strategy over time. An example:

• An investor may decide they want 60% of their portfolio in stocks (equity) and 40% of their portfolio in bonds (fixed income). In the equity space they may decide to allocate 80% of their investments to large cap companies and 20% to international companies. In the fixed income space they may decide to focus 100% on short term government bonds.

While most people will understand the concept illustrated above, many will be extremely fearful of actually putting the concept in to practice. The biggest reason for this is fear of making a mistake.

There is a wonderful article by Jim Dahle entitled “150 Portfolios Better than Yours” that addresses EXACTLY this point. Dahle writes online as “The White Coat Investor” – a doctor that has taken on the task of de-mystifying the world of finance for his peers. In the article, he goes through a number of different asset allocations. The key here is two-fold:

• Even amongst the experts there is a huge variety of opinions on what is the “right” asset allocation.
• It is more important to have and STICK TO an asset allocation strategy than WHAT the strategy is.

Asset Classes Explained

Assets are best thought of as places where you can store your wealth. While there are a huge number of specific “places” where you can store your wealth, there are only a few basic “classes” where you can store it. These include:

• Owning a company – Examples of this include stocks as well as private companies that you may personally own.
• Owning a debt – Examples of this include bonds (loans from companies or governments) and individual IOU’s (the $10K that you loaned your kids).
• Commodities – Examples of this include gold, timber, etc.
• Real Estate – Examples of this include your home, farmland, etc.
• Collectibles – Examples of this include your coin collection, your stamp collection, your baseball cards, etc.
• Cash – You always have the alternative to keep your wealth in cash. However, due to political risk and inflation cash is not always as safe as it might seem.

Most investors will have a portfolio that consists of owning companies (stocks), owning debts (bonds), and cash. The other asset classes can be included to further diversify their portfolios. However, care must be taken in introducing each of these additional classes.

Beating the Market

As a society, we continually receive signals that we need to “be the best” and “win”. This results in a preconceived notion that if we are to be a successful investor, we MUST beat the market. This internal hard wiring makes us extremely susceptible to pitches for the next best thing. If you take nothing else away from this article, remember this:

• You are not going to beat the market

Think about this for a second. There are thousands of people with MBAs, PhD’s, and super computers whose job it is to figure out how to win at the investing game. They eat, drink, and sleep this stuff. Do you honestly think that you are going to do better than them? If you don’t believe me, believe the studies. You can find one article here that summarizes recent findings on this topic. Want more evidence that you are not going to beat the market? Check out the Callanan Periodic Table of Investments. This chart is one of my all-time favorites as illustrates the performance of various asset classes over time. If you can find a pattern in this chart, you are a better person than I am!

Unfortunately the common investor is seduced far too often into believing a slick marketing pitch and buying the latest and greatest stock or mutual fund. There is a better way – passive investing.

Passive investing focuses on CAPTURING the returns associated with asset classes versus attempting to BEAT the returns associated with asset classes. Passive strategies are normally executed through mutual funds. My preference is to use the strategies based on the Nobel Prize winning research of Eugene Fama and Kenneth French. Another solid strategy is to use widely available index funds. In either case, the focus is on CAPTURING returns versus BEATING returns.

Accepting that capturing the returns is superior to beating the returns is difficult to come to terms with. However, once accepted, it is straight forward to implement an investment strategy based on Grandma’s guidance that all of your eggs should not be in one basket.

Putting Things Into Practice

To put things into practice, you need to follow the following four step process:

1. Determine your exposure to equities versus fixed-income products
2. Determine the asset classes and percentages of each asset class you will use
3. Select a specific investment vehicle for each asset class
4. Invest in the targeted ratios, monitor regularly, and rebalance as necessary

Let’s illustrate this via an example:

• Grandma has $100,000 to invest. Grandma thinks that the right ratio for her is 60% equities and 40% fixed income. Further, she’s a bit fan of simplicity and thinks that the S&P 500 is “good enough” for her equity exposure and the total US bond market would be “good enough” for her fixed income exposure (Grandma didn’t fall off the turnip truck yesterday / she’s been reading the Wall Street Journal for years!).

With this in mind, let’s go through the process for Grandma:

• Determine your exposure to equities versus fixed income products. For Grandma the ratio is 60% equity and 40% fixed income.
• Determine the asset classes and percentages of each asset class you will use. For Grandma, it’s large capitalization stocks for equities and the total bond market for fixed income.
• Select a specific investment vehicle for each asset class. For Grandma she would choose an S&P 500 index mutual fund and a total bond market mutual fund. Good choices for these would be Vanguard’s 500 Index Fund (VFINX) and Vanguard’s Vanguard Total Bond Market Index Fund (VBMFX).
• Invest in the targeted ratios, monitor regularly, and rebalance as necessary. Grandma would invest $60,000 in VFINX and $40,000 in VBMFX. She would then monitor the relative ratios of her investments and adjust on a regular (likely quarterly) basis to maintain the 60/40 ratio.

Now there is another key as to why Grandma is so smart and so successful. She came to accept a long time ago that:

• You can’t teach an old dog new tricks

Both you and Grandma know that she is a living, breathing example of this – she is set in her ways and does not deviate.

Now while there are some negatives about being a strong willed individual. when it comes to investing Grandma’s conviction to her investment approach is critical to her success. The reality is all too many people will read the above process, but will be seduced by the aforementioned allure of beating the market. As a result they will deviate from their strategy and the results will NOT be good. When it comes to investing, there is one key principle that you need to keep in mind at all times:

• You need to have a strategy AND the discipline to stick with that strategy through the market variations.

So there you have it, a lesson in investing from your Grandma. While I’ve had a little fun with the topic, there really is a ton of wisdom that you can learn from those who have a few gray hairs (sorry Grandma!). Developing and implementing a solid investment strategy based on asset allocation is a proven path to investment success. The challenge that most investors face is having the discipline to develop and implement such a strategy as they are seduced by chasing “better” returns.

Hopefully you have taken away a few ideas after reading Grandma’s insights. Further, hopefully you will use her wisdom to evaluate your approach to investing and make the necessary changes. Finally, if you have any questions about the topics covered in this article, feel free to reach out to me at any point in time. I enjoy working with entrepreneurs, corporate executives, and families to define their goals and make sure they have plans in place they are executing to achieve those goals.

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