Wednesday, December 29, 2010

Four Steps to Rebalance Your Portfolio

If you implemented the ideas behind the last six posts, you have a fair idea about how to put together your personal portfolio policy. In previous posts we’ve talked about rebalancing, but never really addressed the question of how often and how best to accomplish it.

I suggest you look at your portfolio at least once a quarter to see if it is still aligned with your portfolio policy. If you enjoy getting down and dirty with numbers, then a monthly review will work even better. If you really, really hate this, but know you need to do it, then push the odious task out to six-month intervals—but recognize you are probably giving away a bit of your long-term performance.

Rebalancing is a four-step process:

Step 1: Determine the market value of all your investments. These days the market value of most of your investments should be available online. (And I know you can get online because you’re reading this.) Add up all the investments in each bucket of your portfolio policy.

Step 2: Compare the current allocation of your investments with your policy targets. I do this as dollar amounts; some people prefer to use percentages above or below their target. For example if large-cap domestic stocks are supposed to be 25% of your portfolio and that should be $100,000, and they actually are $110,000, then under my approach I would show the large-cap stocks as $10,000 too high. The percentage folks would show it as 110% of target (or 10% over target.)

Step 3: Identify any investments that are significantly higher or lower than your target. Rarely will you be exactly on target, and it takes time (and sometimes money) to rebalance your portfolio. Therefore you need to pick a threshold to rebalance. I choose a dollar threshold, so if the deviation is above that amount, I need to do something; below the limit means I can delay rebalancing that particular asset because the class is not significantly skewed.

Percentage devotees will pick some bracket and say that if the asset stays between (for example) 90% to 110% of target, there is no need to rebalance. Outside of the range, they need to do some buying and selling.

If you are in the investing stage of your life, you can often address your imbalances by deciding where to put new money. Sometimes you are constrained because much of your new investment is going into your employer’s 401(k) plan and you can change your contribution allocation a limited number of times a year.

In any event, the time to decide your rebalancing criteria is when you first set up your portfolio policy. If you wait until later, inertia will cause you to let the rebalancing slip (oh, it’s not too far off the procrastinator says) or fervor will cause you to rebalance more than you need (gosh, large-caps changed 1% today, I’d better fix that imbalance right now!)

Step 4: Decide the most effective way to rebalance. To the extent possible, I try to rebalance in my tax-deferred accounts because those sales do not generate taxes. If you’re a faithful reader of my blog, you know I use mutual funds for equities rather than individual securities [see Risk in Buying Individual Stocks 5/26/2010]. I mostly use index funds with no sales or purchase fees. (The rare exception is an emerging market fund with a low redemption fee.) With bonds, I use an online broker. The idea is to keep the transaction costs as low as possible. As a general rule, the higher the transaction costs, the less frequently you should rebalance because transaction costs diminish the benefits of rebalancing.

I maintain both a Rollover IRA and a Roth IRA. I hold some mutual funds in both accounts because many of them have frequent trading restrictions, meaning I can’t buy sold shares back in the same fund for two months. But if I sell (say) the S&P 500 Index in the Roth IRA and a month later I need to buy some back because of a big price swing, I can do so in my Rollover IRA if I have duplicate funds set up.

If you do want to frequently rebalance, and the repurchase restrictions are a problem, split your assets between two mutual fund companies. As long as you keep sufficient funds in each to qualify for the lowest fees the fund company offers, you can circumvent the repurchase restrictions. For example, you can sell Vanguard S&P 500 shares in December and purchase Fidelity S&P 500 shares in January if necessary.

If you only rebalance quarterly, this whole repurchasing issue won’t be a problem for you.

If you have to rebalance using taxable accounts, keep in mind the tax effects of any sales. Try to sell funds with capital losses or small capital gains; but if you can’t do that, it is better to pay some taxes (particularly at a maximum 15% rate) than to allow your portfolio to become significantly unbalanced.

If you use mutual funds with loads or sales costs, I suggest you consider no-load funds and make any new purchases in them. Over the long-term loads are a shackle on your flexibility and net returns—but that’s a different post.

Whatever route to rebalancing you choose, keep it simple so you can implement and stick with your plan. Better to rebalance only twice a year than commit to doing it monthly and then become sufficiently annoyed at the time and hassle that in frustration you stop rebalancing all together.

Following this approach you will usually end up selling winners and buying losers. For individual stocks that may not be a great plan, but when dealing with widely diversified mutual funds, I think of it as shopping in the bargain aisle and funding my shopping spree by selling off things that are becoming more and more expensive (as the price increases.) Unless you have the will of a mountain, you too will be tempted to hold on to a mutual fund “because it’s still going up.” Keep this in mind: if everyone believed those stocks must go up, they would have already increased in price.

Similarly, sometimes it feels like you are throwing good money after bad as some category falls into disfavor. Do it anyway. If you really feel squeamish, spread your purchase out over a few months rather than making it in one lump.

Financial professors have written a number of papers that show the most important determinant of long-term investment performance is the asset mix. I’d like to add that once you’ve made that all-important decision, the next best thing is rebalancing.

A couple years ago I had a financial advisor compare my personal investment returns to an approach using the same mutual funds utilizing rebalancing only once a year. He reported that in each of the five years my rebalancing policy had beaten the benchmarks. Will that always be the case? Undoubtedly not. A year will come when one asset class only goes up, another only drops—and I kept selling the former to fund the latter. In that kind of year I will not do as well as a strategy that does not rebalance, but none of us knows in advance when that is going to happen. Those who followed the tech stock boom up discovered it cratered much more quickly than it climbed. That’s usually the case for bubbles. If you haven’t been selling on the rise up, it will be too late when the crash comes.

An old Wall Street adage goes something like this: Bulls can make money; Bears can make money; Hogs get slaughtered! (Jim’s caveat is that if you can become the CEO the last statement no longer seems to hold.)

The calendar year is about to end. Isn’t this the traditional time for resolutions? How about reviewing (or creating) your investment portfolio allocation policy and rebalancing if things are out of whack.

~ Jim

Monday, December 27, 2010

Developing an Asset Allocation Model (Part VI)

So far we’ve discussed the need to understand your risk tolerance before developing an asset allocation strategy, the four main asset classes we’ll consider, two posts on various asset subclasses and the previous post, which revealed my personal asset allocation policy. This final post in the series will discuss the rationale for my current thinking and what changes might cause me to modify the policy in the future.

As a reminder, here’s the policy I have in place as of 24 December 2010:

Bonds: 44.0%
Short-term Balancing Item
Medium-term 0.0%
Long-term 0.0%
Inflation-protected 15.5%
Pension Actual%

Equities 50.0%
US Large-cap 23.0%
US Small-cap 10.5%
Europe 7.5%
Pacific 3.5%
Emerging Markets 5.5%

Real Estate 3.0%
Commodities 3.0%

Total 100%

I based the overall allocation between stocks and bonds on my risk profile. As we discussed in the first part of this series [link1], each of us has different risk parameters. In my case I (hopefully) have a large number of years still in retirement. While I have hopes of income from my writing, realistic expectations indicate I should discount those hopes and assume I am relying on my current assets to fund my retirement.

Consequently, I need sufficient cash flow to fund each year’s expenses and a mix of securities to provide a real rate of return over and above inflation. The biggest risks to my financial security are (1) longevity, (2) significant declines in asset values and (3) inflation. Given those, I started with a 50/50 allocation between bonds and equities. I then added the two additional classes of Real Estate (REITs in my case) and Commodities (precious metal coins and ETFs.)

I chose to carve the Other category out of the Bond allocation because current rates of returns on bonds are significantly below my long-term expectations. If real rates of returns on bonds were higher than my long-term expectation, I might well be fully invested in the bonds and carve the Other category out of the Equities, or be someplace in between.

Turning to the Bonds: I determine the present value of my defined benefit pension plan annuity. (If you don’t have the wherewithal to do that yourself, send me a note and I’ll send you an excel file with instructions.) I convert the present value into a percentage of my total assets.

Other than the pension, my main bond category is the Inflation-protected bonds. These bonds do a good job of addressing all three of my major risks. I have two different assets included within this subclass: Series I Savings Bonds and TIPs (Treasury Inflation-protection bonds). The target percentage I use varies based on the real rate of return on TIPs. The higher the real rate, the higher the target percentage. For example, at a 2.5% real rate of return, the target percentage is 28%. The minimum and maximum of the target range are 14% and 42%. (If I reach the higher end of the range, I would be cutting into my equity allocation, but I would be happy to do that with an inflation-protected real rate of return of 3.25% or higher.)

When I first started investing in this category, my preferred approach was to utilize Series I savings bonds [link to description of Series I bonds]. Their real rates of return were in excess of 3% at the time and I bought as much as the government allowed. With their current real rate of return at 0%, they are very unattractive. I cherish the Series I bonds I have and probably won’t cash them in until they mature. Consequently, all my purchases and sales now involve TIPs. Real rates have been creeping up recently and I will probably soon increase my target percentage.

With the Federal Reserve actively pushing down interest rates, I do not want to invest in standard medium or long-term bonds. I believe the low interest rates are much too low to compensate for the risk of increasing rates because (1) the Fed stops buying bonds, (2) inflation starts to kick up again or (3) foreign creditors stop purchasing the United States’ ballooning debt. Because of the Fed’s actions, the remainder of my bond allocation is sitting in short-term securities. This consists of money market funds paying almost no interest and short-term CDs and corporate bonds with maturities of less than three years. These will fund much of my spending over the next two-three years.

If real rates of return increase, I may gradually lengthen the duration of my bond purchases and increase TIP holdings, otherwise I’m concerned bonds are the next minor bubble with losses ahead of them. See for example Vanguard’s warning to its investors.

Let’s turn now to Equities. Within the equity allocation I found two issues to address. The first question revolves around US equities: how much to allocate between large-cap and small-cap stocks. The actual market percentage varies depending on the flavor-of-the-year. Sometimes the masses like big stocks; sometimes they go gaga over the little stuff. (The tech boom is an example of this.) I’ve settled on roughly 2/3rds of my US allocation going to large-cap stocks and the remainder to small-cap.

The other question is what percentage of equities should be allocated to US, Europe, Pacific and Emerging Markets? Search the internet and you can come up with widely different views of the market capitalization of the various markets. Vanguard, for example uses: North America 44.0%, Europe 26.7%, Pacific 13.5% and Emerging Markets 15.8%. That would imply that of the non-North American markets, 48% belongs to Europe, 24% to Pacific and 28% to Emerging Markets.

If one were a world denizen, an allocation such as Vanguard’s might make sense, but I mostly spend dollars in the United States, so it makes sense to me to overweight my home country for two reasons. Large-cap US corporations have considerable international operations, but because they are US based, they tend to think in dollar terms and hedge some of their currency risk. Thus large-cap US corporations give me access to foreign markets on a hedged basis. Pure plays in the foreign markets subject me to currency risk. I like some currency risk because it tends to provide diversification and so stabilize asset values. However, at the end of the day I am spending dollars not euros or yen.

So I’ve taken the position that US corporations will account for roughly 2/3rds of my equity allocation. Of the remainder allocated to foreign markets, I have again taken a position that 1/3rd will go to emerging markets with the remaining split between Europe and Pacific more or less based on their relative world allocations.

To summarize, I am overweighting the US by increasing its allocation by about 50% and underweighting the rest of the world by 40%. Within the foreign allocation I overweight emerging markets by almost 20% while underweighting Europe by about 5% and Pacific by about 10%.

I’ve tweaked these percentages over the last decade or so. It is interesting to me that for the longest time most of the investment advice I received or read suggested I should have lower allocations for foreign securities than I had. Recently I have seen a number of articles suggesting larger foreign allocations than I hold—which might be the reason we’ve been seeing net outflows from US domestic stock funds and into foreign stock funds. I have to admit it makes me a little nervous when the world starts agreeing with me.

Any Other subclass that I choose to track needs to be sufficiently substantial to have a measurable effect on diversification and risk/return. I’ve set that minimum as 2% of total assets. Originally I had two subclasses: Real Estate and Precious Metals. This year gold skyrocketed past the point where I thought holding the bullion made sense, so I sold out that position and moved into a couple of commodity indexes as an inflation hedge. We’ll see how that works out. I could argue for higher percentages for each of these two subclasses and in fact moved the precious metals from 2% up to 3% over time—mostly through inertia of price increases and a reluctance to sell, until I did.

If something in this analysis struck you as not making sense or it made you feel a bit uncomfortable as you read it, I suggest you try to understand the basis of your feeling. Perhaps I’ve introduced a different way of looking at something that you might want to consider; or perhaps my approach isn’t right for you and that explains your discomfort. The whole point is to make good decisions for yourself. After all, I have to live with my choices; you get to live with yours.

In the next post I plan to talk about the when and hows of reallocating your portfolio.

~ Jim

Friday, December 24, 2010

Developing an Asset Allocation Model (Part V)

So far we’ve discussed the need to understand your risk tolerance before developing an asset allocation strategy, the four main asset classes we’ll consider and two posts on various asset subclasses.This post puts it all together in a personal Asset Allocation Policy. This post and the final post will present my rationale for the allocation I’ve chosen.

Before we do that, however, we need to deal with two assets: Personal Real Estate and Social Security.

Personal Real Estate

My philosophy has always been that my house is my home. If I happen to make money on its appreciation, great, but my main reason for buying a house is to live in it. I am fortunate enough to have two houses, one north and one south. When I become sufficiently decrepit, I will sell the northern house and live full-time in the south. More decrepit and I’ll end up selling the southern house and living in an assisted care facility or nursing home (ugh).

I have not bought and do not plan to buy long-term care insurance. I treat my housing as that insurance. When it comes to my personal balance sheet, I show my two homes as “Other Assets.” When it comes to my Asset Allocation Policy, I do not include them at all. That’s just my way of doing it; you may choose otherwise.

Social Security

I noted earlier that I treat the defined benefit pension I receive from a former employer as a bond. By parallel reasoning, I should treat Social Security as an indexed bond because the monthly payments are linked to CPI. But I don’t.

I do not have post-retirement medical insurance from my employment. I am purchasing catastrophic coverage until I reach Medicare eligibility, at which point I will have whatever Medicare coverage is then available. (It has to change, but that’s a topic for another post.) I’m sure I will need to purchase a supplementl policy to cover what Medicare does not.

I really have no clue where healthcare in the United States is going, and so for now I have olayed the entire issue by keeping the value of my future Social Security Payments off balance sheet. My implicit assumption is that the red cape of my Social Security payments will cover the charging bull of my post-65 medical costs. It’s inaccurate, mismatches timing somewhat, but it works for me—which is why you won’t see Social Security in my Asset Allocation Policy.

If you (very reasonably) take a different approach toward your Social Security Benefits, I recommend you treat it as an inflation-protected bond.

Jim’s Asset Allocation Policy

So here we are after four and a half posts at the moment to cue the drummer and press the red button that activates the stage curtain. It retracts and reveals:

Jim’s Asset Allocation Policy as of 24 December 2010:

Bonds: 44.0%
  Short-term Balancing Item
  Medium-term 0.0%
  Long-term 0.0%
  Inflation-protected 15.5%
  Pension Actual%

Equities 50.0%
  US Large-cap 23.0%
  US Small-cap 10.5%
  Europe 7.5%
  Pacific 3.5%
  Emerging Markets 5.5%

  Real Estate 3.0%
  Commodities 3.0%

Total 100%

In the final post of this series, I’ll discuss the rationale for my current thinking and what changes might cause me to modify the policy in the future.

~ Jim

Wednesday, December 22, 2010

Developing an Asset Allocation Model (Part IV)

So far we’ve discussed the need to understand your risk tolerance before developing an asset allocation strategy and the four main asset classes we’ll consider. In the previous post and this one, we are looking at asset subclasses and how to handle them.

Recall that we broke assets into four general categories of assets: Cash equivalents, Bonds, Stocks and Other.

Stocks (Equities)

There are almost as many ways to classify equities as there are people willing to classify them—which are mostly mutual funds and brokerage firms marketing the latest and greatest fund for your immediate purchase.

Some choose to look at dividend paying vs. those stocks that pay no dividend. Others look at the historical or projected future growth in earnings and split equities between “growth stocks” and “value stocks.” Pundits don’t always agree on which is which and occasionally you will find the same stock on both lists. Further, a growth stock can stop growing (a bad thing) and a so-called value stock can become a faster grower (a good thing).

I prefer to consider stocks based on their size (market capitalization) and geographical location (Domestic, Foreign “mature” market, Emerging Market).

With regard to market capitalization, I use the admittedly arbitrary split of the S&P 500 as large and all others as small. (Many argue there is a mid-cap that covers the larger portion of the market—and if you want to make that distinction, I have no objection.)

Regarding geography, there are four main markets: North America (dominated by the US), Europe (mature), Pacific (mature) and Emerging Markets (which cuts across all continents.)

When people talk about geography, they are really referring to the geography of corporate headquarters. Yet McDonald’s (US Corporation) earns the vast majority of its income outside the US, as do many other US corporations. Japanese car companies sell a lot of cars in the US. There is no easy pigeonhole where you can put international corporations. Many larger corporations across the world have significant exposure to the Emerging Markets.

Is it necessary to look at each stock within a mutual fund you own and allocate it between the various geographical areas—and if so, based on what? Revenue, profits or investment? I don’t have the time or energy, nor do I think it a worthwhile proposition.

Those companies headquartered in the Emerging Markets deserve their own subclass. They are generally smaller companies, their financial markets are less transparent, currency fluctuations can be significant and they can be subject to bubbles (of optimism or despair) because it takes much less money to flood or starve these smaller markets. It is a risky subclass. It is also a subclass that does not tend to move lockstep with other equity markets, another good reason for keeping it separate.

Rather than try to keep track of foreign large-cap versus foreign small-cap, I use separate subclasses for Europe and Pacific. Although there is much in common between these two areas (as there is between each of them and North America) there are also significant differences. I have found that rebalancing between Europe and Pacific a useful technique.

Only within the US do I keep separate subclasses for large-cap and small-cap.

To summarize, I keep track of five equity subclasses:

US Large Capitalization
US Small Capitalization
Emerging Markets


Here’s my personal approach to the “Other” subclasses. If it does not reflect at least 2% of your portfolio, then lump it with something else. With that stipulation, I currently have only two subclasses: Real Estate and Commodities.

Real Estate for me includes REITs. It does not include my personal residences. (I’ll talk about the reasons why in the next post where I give you the reasons for my current asset allocation policy.) If I had rental property, I would keep that as a separate subclass. Farm land or timber partnerships might also deserve their own subcategories within real estate if they meet the 2% threshold. Similarly, if my commodity position were sufficiently large and diverse, I might split out bullion holdings from other commodities because they react differently to economic and psychological forces.

I don’t have that large a portion of my assets in the "Other" category, so for me Real Estate and Commodities covers the gamut of my needs.

Next up: Putting it all together in an Asset Allocation Policy.

~ Jim

Monday, December 20, 2010

Developing an Asset Allocation Model (Part III)

So far we’ve discussed the need to understand your risk tolerance before developing an asset allocation strategy and the four main assets classes we’ll consider. In this post and the next, we’ll look at asset subclasses and how to handle them.

In the last post we broke assets into four general categories of assets: Cash equivalents, Bonds, Stocks and Other.

Cash Equivalents

Cash equivalents should not need any subclasses since the whole purpose of this category is to be ready cash. Whether you are holding $100 bills, have a checking or savings account, short-term CDs or money market accounts is of no matter.


I think of bond subclasses as having three dimensions.

One dimension is the time until maturity. I use three categories: short, medium and long.

Short: Up to 3 years.
Medium: 3-10 years
Long: Anything 10 or longer.

A second dimension is who is responsible for paying the bond.

US Government
Agencies of the US Government (for example Fannie Mae)
State or Local Government
US Corporations
- Investment Grade
- Junk Bond
Foreign Governments
- Mature Markets
- Emerging Markets
Foreign Corporations
- Investment Grade
- Junk

The third dimension is a catch-all that includes the other characteristics of the bonds:

Discount (zero-interest)

Good heavens, we could have fifty or more subclasses of bonds! Yes, but you don’t need that many. It is important to avoid purchasing any security you do not fully understand. (How many people understood CMO’s—Collateralized Mortgage Obligations—for example. If they had, the banking system may have avoided its recent near collapse. But I digress…) So when you purchase an individual bond or a bond fund, you’ll want to understand all of its characteristics, but our main discussion point is your personal asset allocation policy, and for that we can combine categories.

I use six subclasses only:


I use the first three categories to loosely categorize my interest rate risk for those bonds where interest rate risk is the primary determinant of my overall return.

Properly speaking, the financial tool for understanding interest rate risk is a bond’s duration rather than its maturity. The idea behind duration is to reflect when you expect to receive payments for the bond. A zero-income bond with ten-year maturity, for example, pays nothing until the end of ten years. It is subject to higher interest-rate volatility than another bond with ten-year maturity that pays semi-annual interest and pays back one-tenth of its principal each year. The second bond has much less money at risk in future years. Consequently, the effect of interest rate changes is smaller on this bond than on the zero-coupon bond.

Unless I am dealing with a zero-coupon bond or mortgage-backed security (which pays principal back as the mortgagees make their monthly payments), I rely on maturity to classify it. For callable bonds (one the issuer can choose to “call in” – i.e. pay back – before maturity, which they are likely to do when the bond’s interest rate is higher than current rates) I use the call date if I think the bond might be called and otherwise I use the maturity date to classify whether it is a short, medium or long-term bond.

Inflation-protection bonds are a different cat with their own sets of risks and rewards. While I have loosely stated my main financial objective is to not run out of money before I die, what I really mean is I want to maintain at least a certain minimum standard of purchasing power until my demise. Because Treasury Inflation Protection Bonds (TIPs) directly reflect CPI-measured inflation in their investment returns, they are an important class for me—and I monitor them separately.

Corporations are the primary issuers of junk bonds, although some municipal bonds also have sufficiently low ratings to qualify them as junk. In recent years I have avoided junk bonds. Junk bonds have higher expected returns than bonds from quality issuers because the risk of default is much higher. In addition to the effect of interest rate movements, how the company is doing financially significantly influences the financial performance of the bond. [If the company starts doing better, the risk of default declines and the bond price increases; if the company’s performance worsens, the risk of default increases and the bond price declines.] Because of the significant effect company performance has on the bond price, when I do own them I keep them as a separate category.

Foreign bonds, whether corporate or government, have one additional risk that causes me to segregate them as a separate subclass: they are subject to currency fluctuations. If the dollar strengthens relative to a particular foreign currency, all other things equal, the bonds of that country lose value in terms of the US dollar. I buy things with US dollars—that’s the purchasing power I want to preserve.

Some funds holding foreign bonds hedge the currency risk. If the fund hedges most of the currency risk (say at least 2/3rds), I wouldn’t bother with a separate subcategory. Any less hedging, then I want to add a category to recognize the additional risk I have taken by allowing currency fluctuations to affect the value of my holdings.


I am lucky enough to have a corporate pension from one of my former jobs. I consider it a bond because its value to me closely resembles that of a bond paying monthly interest with no maturity date. My monthly payments are fixed and will continue as long as I do. Like a bond, this stream of payments loses value if inflation kicks in because I can buy less with my monthly payments. Should we experience deflation, the value of my monthly payments rises because I can buy more with them.

Since my pension came as the result of a qualified corporate pension plan (and is relatively modest), the Pension Benefit Guarantee Corporation guarantees all of my benefit payments (unless Congress retroactively changes the law.) Given these characteristics, my pension looks a lot like an insured bond and that is how I value it.

Social Security is also bond-like, but unlike my corporate pension, future payments (more or less) reflect inflation subsequent to the start of payments.

Later in this series of articles, I’ll discuss the specifics of how I recognize the value of my corporate pension and Social Security in my personal asset allocation policy and balance sheet.

Next up: Asset Subclasses in Your Portfolio (Stocks and Other Investments)

~ Jim

Friday, December 17, 2010

Developing an Asset Allocation Model (Part II)

In the first part of the series we discussed the need to understand your risk tolerance before developing an asset allocation strategy. In this post we’ll talk a bit about assets classes you might consider.

I think of the world as made up of four general categories of assets: Cash equivalents, Bonds, Stocks and Other.

Cash Equivalents

For our purposes, cash equivalents consist of assets that you can readily turn into cash without suffering asset price volatility or a significant cost for the conversion. Stuffing your mattress with currency is one way to hold your cash. Most people choose to use checking accounts, savings accounts and money market funds that pay a modicum of interest. Treat Certificates of Deposit (CDs) as a cash equivalent if there is no penalty for cashing them in early. If the penalty is as much as one month’s interest, I would still consider it as a cash equivalent. But if you can’t cash it in before maturity and are required to sell it to a third party or if there is a sizeable penalty for cashing in the CD, then I would consider it a bond.


We’ll consider any loan not counted as a cash equivalent as a bond. The loanee can be a corporation (corporate bond), a state or local government (municipal bond), the US Government (Treasury bills and bonds), foreign corporations or governments, or a loan to Junior that you really do expect him to repay.

Some bonds come with periodic interest payments; others are sold at a discount from the maturity value and you collect earnings when the bond matures.

Some bonds are secured by assets. (For example, when you take out a car loan, the loan—a bond from the bank’s perspective using our definition—is backed by your car. If you don’t make the payment, the bank takes your car.) Some bonds are backed by plant and equipment, others by tolls paid on a highway. Other bonds are backed only by the full faith and credit of the organization.

For reasons I’ll explore in a later piece, I include pensions due me as bonds. I am lucky enough to have a corporate pension from one of my former jobs. Most of us have Social Security. Both have characteristics that make them bond-like.


I would substitute the word equities for stocks because that’s how I think of the category. An equity position means you are eligible to share in the profits of the company while it is an ongoing concern and share in its liquidation value if it stops doing business. (The liquidation value is often zero because bond holders have to be paid off before the equity holders.) Partnership shares in a business would fit here.


Real Estate is included under “other” as are precious metals, commodities, art, the baseball card collection your mother didn’t throw away and anything else that has value.

I can see the purists out there pulling out their micrometers to measure the fit of some asset or another with its assigned bucket. “What about convertible bonds?” (bonds issued by corporations that can be converted to common stock under certain conditions), they say. If most of a convertible bond’s value is attributable to its coupon payments and principal return, call it a bond. If most of its value relates to the fact you can convert it into an equity position in the company, treat it as a stock. When in doubt choose those characteristics that most determine its price.

Could you have more classes? Of course. In the next two posts we’ll consider subclasses and discuss which ones are worth separate recognition.

Next up: Asset Subclasses in Your Portfolio

~ Jim

Wednesday, December 15, 2010

Developing an Asset Allocation Model (Part I)

In my May 24, 2010 post I discussed rebalancing portfolios and how that assists in buying low and selling high. This week I rebalanced because stocks have been going up and bonds declined in value, so my portfolio was off kilter.

In addition to rebalancing this week, I also changed the target percentages for various asset classes. The percentage allocation to asset classes should be at the core of any investment program. One size does not fit all. I knew someone who got an A on an MBA finance exam when she answered a question about asset allocation by indicating she was completely risk averse. Preservation of principal was her only objective and therefore she would keep all of her money in cash, short-term treasuries and government insured bank accounts and money markets.

As long as the US government does not default, this investor will meet her objective of capital preservation. Since I don’t have sufficient assets to live off the current paltry interest return treasury bills, money market funds and the like pay, I need to take more risk in order to (hopefully) get greater return. My risk tolerance and yours may not be the same. We may have different objectives (mine is to not run out of money before I die) for our investments. If you are not sure of your objectives and risk tolerance, you can use any of a number of online tools to help define them. Use several since they have different implicit assumptions and their average advice may be more accurate than any one model.

I’ve periodically tweaked my asset allocation as I moved from employed to retired. Contrary to many popular wives tales, asset allocation need not change on account of age per se. The critical components are (1) whether you are accumulating, spending or in transition between the two, and (2) when you need to spend the money. Bull markets are never a problem; what happens to your assets in the inevitable down market cycles and how that affects your plans is the key issue.

When you are accumulating wealth, bear markets can be good things. You are a buyer regardless of market conditions. If you have $1,000 to invest, you will get twice as many shares if XYZ sells for $10 a share than you do when XYZ sells for $20 a share. If you have many years of accumulating to go, your future investments likely far outweigh the value of your current portfolio, and so market ups and downs are of little concern.

In the spending phase, you no longer have “excess” income to invest. Your portfolio accumulation is finished and you no longer benefit from buying at depressed levels after a market “correction.” Judicious rebalancing will help, but, for the most part, the only way to adjust to decreased investments is to decrease spending or dying earlier. Neither are pleasant alternatives. While a portfolio of Treasury bills will solve the problem of investment losses, they provide little real return, which leads us back to the problem of insufficient funds to live solely on Treasury bill income. Most of us must take some risk in our portfolio.

I define the transition phase as the period before retirement in which the size of accumulated investments has become large enough that future annual additions can no longer make up for large market declines. The earlier you start to save, the quicker the transition period comes.

Next up: Asset Classes to Consider in Your Portfolio

~ Jim