Research says that investor
choice of asset class (whether to buy stocks or bonds or stick to cash equivalents) is the most important determinant of investor returns. Confusion about what to do with this knowledge, however, has led investors and even most professional financial planners to make costly mistakes in developing successful asset allocation strategies. In the face of this confusion,
a simple “red money” and “green money” approach to developing portfolio strategy may be the most important decision investors make regarding their own investment approach. For a full explanation of this color-of-money approach, keep reading.
An investor’s allocation between stocks and bonds should be based on current market conditions. Most financial journals and financial advisors portray “market timing” as ineffective – at best – and very costly to those who make a mistake. True, mistakes in this area can be costly, since asset allocation is the most important determinant of investor returns. However, a
static approach (deciding not to make a decision) is not the solution. Just because investors don’t have a crystal ball that lets them know the future doesn’t mean they should ignore risk in a high-priced market. Nor, when stock prices have fallen in spite of economic fundamentals that are improving, does it make sense to ignore the higher potential return that stock investors enjoy during the good times. Just because it is impossible to be 100% accurate in timing the market, investment advisors (and their clients) should not ignore the most important investing decision they will make – the allocation between stocks versus bonds or cash.
Plenty of obstacles stand in the way of making rational asset allocation decisions. For example, many brokers use a black-box approach, which clients don’t understand. A computer survey might indicate that an 80% allocation to stocks is right. And that allocation is supposed to be “right” for all market conditions. The problem is that
unless investors truly understand why their allocation is appropriate, they won’t stick to it in good times and bad and are vulnerable to selling stocks in the midst of a stock market panic, like what occurred in the final months of 2008. If the asset allocation strategy fails the investor at that most critical point in time, it is worse than useless. It is, in fact, a major part of the problem.
Overly simplistic “
rules of thumb” aren’t much better. These rules, based mostly on investor age or cash distribution rates, ignore the myriad of financial and emotional variables that make each of us unique. Sure, an investor may have reached an advanced age where he won’t even buy green bananas for fear that his time horizon is so short, but if that investor happens to be worth a billion dollars, he is actually investing for the next generation and shouldn’t be avoiding stocks just because he happens to be old.
Most asset allocation approaches are inflexible and don’t reflect current market conditions. Regardless of whether the market is overpriced and poised to fall along with a teetering economy, or whether stocks have fallen 50% in price and are being priced at “blue-light special” prices,
most asset allocation strategies establish a fixed “strategic” weighting of stocks and bonds and allow no flexibility for managing portfolio risk. In contrast, most foundations and institutions have developed a fixed (static) allocation in their investment policy statement but also allow for tactical changes within a given range. Instead of mandating that stocks comprise 50% of the pension portfolio, investment managers are given a range (say, 35% to 65%) within which they can operate.
Most investment managers, on the other hand, are given an allowable range but choose to huddle around the mid-point. It’s amazing how many professional managers are perfectly happy to charge exorbitant fees for managing investments but refuse to actively manage the portfolio’s stock/bond allocation, the most critical variable of all.
Developing an appropriate strategy requires a comprehensive view of the investor’s age, available resources, upcoming liabilities, risk tolerance, and previous investing experience. Investors need current market information to implement rational tactical changes to the strategic positioning.
May-Investments offers a half-dozen different approaches to asset allocation and selects the one that makes the most sense to clients. For many, our approach separates the portfolio into red money and green money buckets.
Green money is “safe” money that might be used to meet near-term obligations for, say, the next 10 years. The rest of the money –long-term almost by definition – we call “red money.”
By segregating green money from red money, only long-term money is invested in volatile asset classes, and clients have time to recover from significant market declines. Our
red money portfolios are actively managed, reducing stock exposure and increasing bond exposure at times when the market is falling. All tactical moves, such as reducing equity exposure when markets are selling off, occur in the red money portfolio.
Most importantly, clients understand the specific purpose of the two buckets of money. They have the confidence of knowing where they will be getting income for the next few years and can take comfort in knowing that they should have time to recover from market losses if red money portfolios go into a downward spiral.
In the short run, knowing where you will go to get your grocery money is the most important thing. With long time horizon portfolios, being invested in stocks when they are going up and getting out of the way of a stock market decline are the most important determinants of portfolio return. A proper allocation among stocks and bonds and cash, even though it is never exactly right, is the most important element in every investor’s portfolio strategy.
Douglas B. May, CFA, is President of
May-Investments, LLC and author of
Investment Heresies .
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