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
Europe
Pacific
Emerging Markets

Other

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

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