Understanding Asset Allocation


This week, we’ll dig a little deeper into the questions that I ask myself when allocating capital.  I created the chart (above) to show the difference between my optimal, and my actual, capital allocation.  Similar to a business plan, or training strategy, the optimal plan isn’t always optimal.

First, let’s examine the terms.  If my SOLE objective was investment return then a reasonable strategy to follow would be:

  • Drive personal expenses as low as possible;
  • Invest in broad index funds with low fees; and
  • Keep whacking cash in the funds on a monthly basis.

Funds that I’d like for that purpose might be Vanguard (Total International Stock Index; Total Stock Market Index; and Total Bond Market Index).  The main thing that I’d need to figure out is how often I wanted to rebalance my portfolio.  This strategy is about as close to a sure thing as you can get over a lifetime.

For many people that I come across, this strategy would be far, far better than whatever else they could dream up.  For a population of investors, it is the optimal solution.  As a group, we can’t beat the average — we are the average.  Additionally, when we take an average return and overlay standard financial advisory fees, and transactions costs… an active strategy is doomed to underperform.

My current personal allocation is a bit cryptic, so I’ll explain:

  • Cash – easy one… that’s capital waiting to be allocated at some stage
  • Real Estate – I wrote about Real Estate Valuation before Christmas
  • Nominal – assets that I suspect will hold their absolute value; as any increase in value will be balanced by their cost of ownership.  An example would be my house (when I factor in taxes, insurance, maintenance).  I’ll end up getting back what I paid for it.
  • Psychic – assets that make me happy, or enable me to execute my life plan in harmony.  These include: depreciating assets (bikes, cars, RVs, trailers) as well as assets like art/jewelry where it’s difficult to justify any financial rationale for their purchase.

Why do I have half my net worth sitting in the Nominal/Psychic category?  I do wonder at times!

The simple answer (or rationalization) is life isn’t solely about financial return.  What I’m seeking to optimize is a life with meaning, rather than a number when I die.  That said, I over-invested in my house and given transaction costs/hassle factor/psychic returns… it’s too painful to change course.

The reason I like Real Estate has to do with information and cycles.  Like all markets, mortgage and property markets move in cycles.  Right now they are cycling down.  The unique thing about real estate over, say, stocks… is the opportunities for (me to have) superior information.

That said, even if I am right, with agent fees on real estate… as an asset class… it is a lousy place to be a trader.  So, I’m not looking for trades, I am looking for reasonable deals with a fair return.

So what’s the right answer for you?  I’ll offer four tips.

  1. aim to be reasonable, rather than right.  You don’t need to hit a home run, you do need a reasonable, long term strategy.
  2. any strategy that requires lots of change will prove sub-optimal due to taxes, transaction fees and our collective inability to outperform each other.  If you happen to “win” then you got lucky with your speculation.
  3. understand, deeply, what makes you happy and what causes you pain.
  4. invest on the basis that, collectively, we suck at forecasting.  

Quirks that help me stay happy:

  1. Movements in the value of my real estate are hidden from me.  What I see is the rent checks coming in.  
  2. I set my expenses up so that I can feel good about writing checks to my friends and local businesses.  I write checks to Monica and my financial assistants and they handle paying bills that might cause me irritation.  When I go on holiday, Monica pays for everything — together we agree an overall budget then I remove myself.
  3. If I buy a low return asset then I make sure that it has a huge psychic return for a member of my inner circle.
  4. I treat myself with time, not trinkets.  My luxuries are training with friends, writing and reading books.

If you are deviating from the optimal plan then be wary that you aren’t chasing return so that you can consume more.  When things go wrong, it’s nearly always borrowed money combined with a desire for unreasonable consumption.  

Similarly, if you are an endurance athlete then use this exact rationale to examine your relationship with training stress.  Injury and burnout come from being greedy.  The patterns that repeat in your training life have already dictated your current life situation.  In this sense, past performance is very likely to indicate future results.

While we are motivated by consumption, a life with meaning flows from service, personal excellence and harmony.