Financial Endurance
“Let every man divide his money into three parts, and invest a third in land, a third in business, and a third let him keep in reserve.”
-Talmud, Circa 1200 B.C. – 500 A.D.
I was truly surprised to find this 2,000 year-old proverb recommending an investment concept that has become most popular since the early 1990s (that’s 1990s A.D. in case you had any doubt). Just as we are baffled by how ancient civilizations had the technology to build fascinating structures such as the pyramids of Egypt, who would have thought they would have been so advanced in constructing investment portfolios way back before the start of the Common Era?
As the unnamed ancient scholar suggested, it is prudent for investors to invest a portion of their wealth in different types of assets rather than putting all their sheep in one basket. In today’s terms, the wise scholar might be recommending investments in hard assets (real estate, precious metals, commodities and collectables), equities (stocks, preferred stocks, partnerships, business interests, etc.) and income-oriented assets (bonds, loans, cash, etc.). However, I’m not quite sure the scholar provided any guidance regarding Bitcoin, so let’s save that topic for another day.
Since the 1990s, brokers and investment advisors have recommended similar asset allocation strategies as the basis for offering more and varied investment products and services. While this approach appears extremely convenient and self-serving for those who make their living selling investments or providing advice, it does have a great deal of merit and may be appropriate for just about anyone with long term financial goals.
Asset allocation is a term used to describe how an investor spreads their wealth among different investment categories (aka asset classes). The idea is that by holding investments in asset classes whose performance are not closely correlated, the portfolio will be less likely to suffer substantial losses. For example, bonds and real estate may perform well at times when stocks are falling, such as during the 2000-2003 bear market. A conservatively balanced portfolio may have actually made money during that period or lost substantially less than a portfolio of only stocks, especially technology stocks which were ground zero as the “dotcoms” became “dotbombs”.
If the value of your portfolio fluctuates widely, the chances are that it is more heavily weighted in equities with greater risk and volatility, such as aggressive growth stocks or emerging market stocks. If the wild ride keeps you awake at night, you may need to revisit your asset allocation by reducing riskier assets and shifting more toward less volatile investments such as dividend-paying blue chip stocks, preferred stocks and bonds which should have a stabilizing effect on your overall portfolio. Similarly, if a very stable portfolio heavily weighted in less volatile assets, such as cash, CDs or short term bonds, is not providing enough growth to meet your longer term objectives, you should consider adding some more equities to the mix. Many professional advisors and financial planners are equipped to help construct an appropriate asset allocation strategy based on your specific needs, goals and comfort with risk. It is extremely important to discuss these factors with an advisor periodically to ensure that you are on track, as your personal situation will likely change over time.
In a groundbreaking study published in 1986 by pension management guru Gary Brinson, and confirmed in more recent academic studies, greater than 90% of an investment portfolio’s long-term performance is directly attributable to how it is divided among the different asset classes. While that factoid may not have just rocked your world, this may hit home if we take it a step further. This means that the individual security selection (aka stock picking) and market timing activities on which most investors place the highest value, are actually among the least important factors contributing to their portfolio’s performance over time. So, while stock picking and guessing where the market is heading can be a lot of fun and may give you something to discuss at cocktail parties, it does little to distinguish your investment returns from another portfolio with a similar balance among the broader asset classes. This begs the question why we pay so much for these relatively low impact functions and relatively little for identifying the most appropriate asset allocation to meet our specific goals and tolerance for risk.
In the coming weeks, in this column, I will provide some more nuanced approaches toward asset allocation as well as some practical investment solutions for how best to implement your asset allocation and other investment strategies. Among the topics I will cover include: