Last week, I wrote about asset allocation. By far the most common approach is strategic asset allocation. By definition, this is the long-term strategy. How much of a portfolio should the investor allocation to cash, stock and bonds?
Much research has shown that most of the level of return is determined by the choice of asset allocation. The same is true of volatility (which I don’t believe approximates risk). If I choose all stocks, I’ll have stock-like returns (probably higher over a long period of time), whereas if I choose all bonds, I’ll have bond-like returns (probably lower, but more likely to be positive over the short and medium term). If I mix stocks and bonds, my portfolio will act partially like a stock and partially like a bond. This is neither difficult nor surprising.
The only reason to keep cash is to be able to take advantage of buying opportunities or to be able to produce income. Otherwise, cash will only reduce the portfolio return. In the two rare cases where cash might be valuable, it would probably not be best. If people lose faith in the financial system, you’d be better off owning gold (or canned food and a gun). In the case of deflation, you’d probably be better off owning government bonds.
The true decision then is between stocks and bonds. I can think of two reasons to own bonds, either if you require guarantees (like large pension funds) or if you have enough capital that you can afford the lower income bonds (currently) provide. Suppose you have $1 million, but only want $30,000 per year income. Why risk your capital investing in stocks, when you can produce your required income from bonds? In a very large portfolio, an investor may choose to have a certain amount of guaranteed income, perhaps $2000 or $3000 just to cover the very basic lifestyle costs. The rest could come from stocks, but at least if anything went wrong, the bond portion of the portfolio would continue to provide income.
Stocks provide dividend income and long-term capital gains. This combination produces (over a long enough timeframe) higher returns than cash or bonds. Because of my young age and the likelihood that I’ll return to work at some point, I prefer to keep my portfolio 100% in equity. This means I experience the ups and downs of the stock market, but I also earn the returns.
Let’s use an example of a portfolio that is balanced 60% stocks, 35% bonds, 5% cash. Over the course of time, stocks and bonds will perform better or worse. This leads to opportunities to rebalance. Rebalancing will actually reduce returns by selling winners as they continue to grow, while buying losers that are languishing. However, it imposes rigour by helping to buy low and sell high. For someone who is undisciplined, it might produce a sub-optimal return, but a far better return than what they would achieve by jumping in and out of the market.
I don’t believe that there’s much point to strategic asset allocation. I also believe that rebalance produces sub-optimal returns. That’s why I spend more time on tactical asset allocation, which I’ll explore next time.