Thursday, February 26, 2009

Asset Allocation - A Potential Key to Success

Let's assume that there are three asset classes: Equity, Fixed Income (Bonds), and Cash.

Generally, these three classes are generalized as follows:

Equity - Highest volatility, highest potential for growth and gains (let's say 8%)
Fixed Income - Moderate volatility, moderate gains (let's say 4%)
Cash - No volatility, Low to no gains, incredibly liquid (let's say 0%)

Let's also assume that you are relatively young and looking for growth (let's say 20's to 40's) and that you have 100k to invest. Your allocation might look something like this (numbers will vary based on your individual risk tolerance profile):

E - 50% - 50k
FI - 30% - 30k
C - 20% - 20k

Now let's say that things go according to plan and your portfolio next year becomes:
E - 50k * 108% = 54k (51.3%)
FI - 30k * 104% = 31.2k (29.7%)
C - 20k = (19%)

Your portfolio is now worth $105.2k. If you were to re-balance your portfolio, you'd move some of the value received from equities into fixed income class (.3% worth or ~$315.60) and cash (1% worth or about ~$1.052k). I think this is the most "true" definition of "profit taking" that we often hear about on stocks news shows, where a calculated reallocation of capital takes place from one class to another more liquid class (cash).

Having said that, how does this protect us from huge crashes (as I suggested they might in a previous post)? Well an indicator that a bubble is about to burst is when equity prices start going too high. However, if you notice, as equity prices start to get too high, you start to liquidate your position out of them (to a position which is more comfortable for your tolerance). You begin to take your gains out and put them in more stable instruments.

How about when prices fall? Say the equity component drops as well. If you follow the strategy, you will take money from your FI or C and bolster your E (in an attempt to profit from low prices). You can clearly see that the old adage "Buy low sell high" is built right into the strategy.

Although hardly a perfect strategy, we can improve it's effectiveness by looking at a few issues which arise:

Frequency of re-balancing - There are transaction costs involved with re-balancing portfolios (it might not be simple nor cheap to just sell equity class investments and buy fixed income instruments). Therefore, you might not be able to re-balance the portfolio every time there is a tiny bit of movement. However, re-balancing should take place at regularly defined time intervals (say a year), OR if a certain threshold is met (your equities gaining 20% in a day might be a good reason to reallocate funds).

Seeding your investments - Another way to "re-balance" is for people who regularly contribute to their investment portfolio through regular contributions (RRSP or just general savings). If your portfolio is misaligned, you can divert the funds you were planning on investing into the appropriate category. For example if you had the ratio mentioned above as a plan, but your portfolio was currently overweight in the FI class, you could put your savings directly into E to balance it out.

Redeeming your investments - If you are close to retirement and taking money out, you can take money out of a class which is overweight. Let's say that in retirement you want to move from the ratio mentioned above (50/30/20) into a ratio of 30/50/20, you might start by cashing out your equities first.

Granularization - When you have the opportunity to add (or remove) funds to (or from) a particular class, such as equity, you can use the same recursive thought process for which individual equities you want to buy more of. For instance, you can purchase more of a stock which is currently at a lower price relative to it's counter parts rather than try to buy a spread of stocks (if transactions would prevent that). Or you could buy more of a particular ETF.

Especially for people who want to be more active in their retirement planning, but aren't experts in investing, I'd rank this as a good strategy to use even right up to investors who would categorize themselves as moderate to highly experienced. Even investment firms will practice this in a more sophisticated way but having a variety of funds available to capitalize on different opportunities in the market (and can be classed by weigh in terms of how much capital exposure is allocated to them.)

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