I think that the first thing is you should have a strategic asset allocation mix that assumes that you don’t know what the future is going to hold.1
—Ray Dalio, hedge fund manager
While at the University of Chicago in 1950, Harry Markowitz was searching for a dissertation topic. So one day, he was waiting for a meeting with a professor and overhead a conversation from a stockbroker. Markowitz wondered: Might the stock market be a good choice?
At the time, this was somewhat controversial. Many Americans still had distrust of the stock market because of the crash in 1929 and the Great Depression. The belief was that it was a place of manipulation by the wealthy.
But Markowitz went ahead anyway. It probably helped that he grew up in a moderately wealthy family. He also did not have any experience trading in the market.
By 1952, his research would pay off. He published a monumental paper called “Portfolio Selection” in the Journal of Finance. He looked at how to analyze risk – which he measured as volatility of securities prices – and return for constructing portfolios. At the heart of this was looking at assets related to each other. By doing this, an investor could better achieve diversification and higher risk-adjusted returns.
Markowitz’s theory would become the basis of Modern Portfolio Theory. As a result, he would win the Nobel Prize for Economics for his work.
In this chapter, we’ll take a look at one of the core ideas of Modern Portfolio Theory – that is, asset allocation. We’ll cover the fundamental ideas and how you can pursue it for your own investments.
What Is Asset Allocation?
On its face, asset allocation is a fairly simple concept. It’s about having a fixed percentage of assets in different types of investments. The most common one is the 60/40 allocation. This is where 60% of your portfolio is in stocks and the remaining is in bonds and cash. The 60/40 approach provides the potential long-term upside from equity growth but has downside protection with fixed-income securities.
But of course, this approach does not fit everyone’s situation. If you are 90 years old, then you may not want as much risk in your portfolio. You may want something like a 30/70 allocation.
Or if you are in your 20s, you have many years to ride out the volatility in the markets. In this case, you might look at an allocation of 70/30 for your portfolio.
Financial planners have sophisticated software that can help come up with the allocation. Often this is based on answering a questionnaire, which takes into account your age, financial goals, and risk tolerance. The software will have the benefit of processing large amounts of market data. There will also be the use of Monte Carlo simulations. This is where the asset allocation is based on thousands of hypothetical market scenarios.
Then again, if you want to do the asset allocation on your own, there are a variety of free online apps. They often take less than ten minutes to fill out. The result will get a nice chart and useful recommendations.
Another option is to use a robo advisor. This is an app that will automate the process by using sophisticated algorithms and data analytics. It will connect to your investment assets from other accounts and have a questionnaire. From this, the robo advisor will build a portfolio, suggest different allocations, and may even provide tax optimizations. This process may take just a few minutes.
The investment minimums are low, say at $500. In terms of the fees, these are also reasonable. They typically range between 0.25% to 0.50% of the assets in your account. There are usually no transaction fees or commissions for trades.
The robo advisors typically use ETFs for the investment options. While there may not be fees for these, there will still be the underlying expense ratios.
Sofi
Wealthfront
Betterment
Acorns
Schwab
ETrade
Some robo advisors have financial advisors that can help with questions or complex planning. This can be via email, text, or video conference. But this will likely increase the cost of the service. For example, Schwab has a $300 upfront fee and monthly charge of $30. There is a minimum account requirement of $25,000.
However, a robo advisor may not necessarily offer access to alternative assets like hedge funds, private equity funds, crypto, and hard assets. This is why you might want to consider using the services of a qualified financial planner. They can provide a more customized asset allocation and financial plan.
Risk Tolerance: Answering questionnaires can be more of an abstract experience. You may think you can handle higher risk. However, when you actually experience a brutal bear market, how will you feel then? It’s common for investors to get extremely nervous and rashly sell their holdings. Often this is the worst time to do so.
Correlation: Over the years, different assets have become more similar in terms of their movements. A big part of this is the speed of trading and the access to information. The rise of index funds may have also resulted in higher correlations. Because of this, when there are major drops in the market, the diversification may not necessarily provide much downside protection since all assets could fall.
Volatility is generally the norm with the stock market. Since the S&P 500 was launched in 1957, every year there has been one 10%+ decline and more than three 5%+ drops.2
Rebalancing
As time goes by, there will likely be some major divergences in the asset classes for your portfolio. For example, you may have started with 60% in stocks and 40% in bonds but then the stock market stages a huge rally. Now the stocks represent 80% of your portfolio.
What to do? You may want to consider rebalancing. This means that you bring down the percentage to your original mix.
The frequency of the rebalancing is an important consideration. Some investors may do this every quarter, six months, a year, or longer.
Then what is best? It’s a tough question. Some investors may wait longer. The reason is that they believe it’s a good idea to “let your winners ride.” After all, when a market is in the bull phase, this is usually not temporary. It could easily last a few years.
On the other hand, this is a form of market timing. It also means you are rethinking your willingness to take risks.
For the most part, asset allocation is not something that is a science. The key, though, is to have a diversified portfolio and exposure to a broad set of asset classes. Ultimately, this could mean having some rebalancing, but not necessarily back to the original percentage.
Yet, for some types of assets, you might want to have more frequent rebalancing. This is the case with volatile investments like crypto. They may surge 50% or more within a couple months. In this situation, it is probably a good idea to take some profits and redeploy them in other asset classes. Just as speculative investments can quickly soar, they can also quickly plunge.
Target-Date Funds
A target-date fund will allocate the portfolio across different asset classes. They are also based generally on the year you will retire. For example, you can have a target date fund for 2030, 2040, and so on. Over time, the target-date fund will change the asset allocation based on risk levels (this is known as the glidepath). So as you get closer to retirement, the investment strategy will be more conservative.
A target-date fund is certainly convenient. You get the benefit of a disciplined approach based on the insights of experienced money managers. They usually focus on index funds, which lowers the costs. Note that target-date funds are popular with 401(k)s and IRAs.
Regardless, there are issues with these funds. Perhaps the biggest is that they are a one-size-fits-all approach. But of course, each investor has their own goals and risk levels. There may also be life changes. If you lose your job, then you may want more conservative investments that provide income.
Academics at the Massachusetts Institute of Technology and the University of Illinois analyzed target-date funds. The main conclusion was that the asset allocation mixes were too conservative.3 The result is that investors likely lost out on potential long-term gains.
One trend is for financial planners to outsource the asset allocation to a money management firm. This is done by using a model portfolio fund, such as from BlackRock, Fidelity, or Schwab. This is often a good solution since it is based on sophisticated analysis and customized to the client’s needs. There are also ways to provide for factors like ESG and taxes.
Emergency Fund
It’s a good idea to have an emergency fund. This is cash you set aside for something like an unexpected bill or a layoff. The general rule is that you should have three to six months of living expenses saved. Although, if the job market is uncertain or you are a freelancer, then you may want this to be longer.
You want to have the money in an account that is easy to access. It could be a savings account. Or it could be a money market fund. This is essentially a mutual fund that is very liquid. The investments are in short-term and high-credit-rated bonds, often issued by the US government. The fund will pay interest, say on a monthly basis. But it is usually a low percentage because of the liquidity and safety of the account.
You will buy a money market fund from a brokerage or mutual fund. But there are also money market accounts or MMAs, which are issued by banks. Because of this, they are backed by the FDIC or Federal Deposit Corporation. If the bank fails, the federal government will cover up to $250,000 per depositor.
Regardless, they both have similar features like check writing and electronic transfers. There are also no loads or exit fees. Something else: money market funds and MMAs have a NAV of $1 and this is supposed to not change. However, during the financial crisis, there was a money market fund – called the Reserve Primary Fund – that “broke the buck.” In response to this, Congress set forth stricter regulations to prevent this from happening. That is, money market funds and MMAs can only invest in certain types of securities and have short term maturities.
Government Money Funds: This has a minimum of 99% of its assets in cash, government debt, and repurchase agreements.
Prime Money Market Fund: These invest in higher risk securities like corporate bonds. As a result, this fund does not abide by the $1 NAV requirement.
Tax-Exempt Money Fund: This holds investments in securities that are exempt from federal taxes. If the fund has municipal bonds, then the interest may be free from state taxes.
Hedging Your Portfolio
Bill Ackman is one of the world’s top investors. He runs the Pershing Square hedge fund.
From 2020 to 2021, he pulled off two major bets on the markets. In February 2020, he realized the Covid-19 pandemic would be a global problem. But it would have been difficult for him to unload all his positions.
Instead, he hedged his holdings. This means he took short positions, which amounted to only about $27 million. But they paid off in a huge way. Within a few weeks, the positions were worth roughly $2.6 billion.4
As for the other bet, he made leveraged trades in stocks that would benefit from the improvement in the economy. Part of this was investing in companies like Hilton, Lowe’s, and Burger King.
The bottom line: In 2020, the hedge fund posted a gain of 70%, and there was a 27% gain the following year.
Of course, Ackman used highly complex investments. But there are much easier ways to hedge your portfolio. As we saw in Chapter 4, you can invest in ETFs – like AdvisorShares Active Bear ETF and ProShares Short S&P 500 ETF – that short the market.
Having some short exposure is definitely worth considering. It does not have to be a big position. It could be a few percentage points of a portfolio. However, in volatile markets, it can help soften the downside.
Day Trading
From 2019 to 2021, there has been significant growth in day trading. This is where people’s main activity is to invest their own portfolio, and this often means focusing on short-term gains.
There have been waves of day trading, such as what happened during the 1990s. But they usually do not last long and are often powered by the frothiness in the markets. The reality is that it is extremely difficult to make money by timing investments.
Regulators are concerned about the current spike in speculative trading. It’s not uncommon for the traders to use leverage, whether through the use of borrowing from their brokers (through a margin account) or using stock options. However, if the markets fall, these positions can generate substantial losses.
A key concern of regulators is a practice called “payment for order flow.” This is where a brokerage firm will get fees on allocated transactions to market makers, which are Wall Street firms that handle transactions in certain stocks. They do this by making profits on the differences with the bid and ask prices on the securities.
The order flow payments are considerably higher than for regular stock. Regulators are worried that brokerage firms are financially incentivized to encourage risky trades. The order flow payments may also mean that investors take on higher costs for the trades.
Something else to consider: Financial apps – like Robinhood – use gamification to encourage more trading. Again, this can increase risky behavior.
At this writing, the regulators have not enacted any rules. But this could happen within the next few years – and this could have a major impact on the markets.
Elon Musk is the richest person in the world, with a net worth of $235 billion. So you would think his financial matters are very complex? Not according to him. In an interview, he noted his financials are not a “deep mystery” and that he could do his own taxes in a few hours.5 He also mentioned that he does not use any offshore accounts or tax shelters.
Conclusion
Asset allocation can help to improve the risk-adjusted return on your portfolio. But this is based on factors like your goals, age, and tolerance for risk.
There are various ways to use asset allocation. You can use an online calculator or the assistance of a financial advisor. There are also robo advisors that automate the process. Then there are target funds that are based on your age.
Besides this, it is recommended to have a certain amount of your assets in cash. This is for an emergency fund.
You might also want to consider hedging your portfolio. Even a small amount in a short ETF can provide some downside protection.
In the next chapter, we’ll take a look at benefits.