The Liberty Portfolios: Building Blocks of Asset Allocation

Posted: Jul 21, 2016 12:01 AM
The Liberty Portfolios: Building Blocks of Asset Allocation

So far I’ve written broadly about investments. Now I’m going to start moving into articles about how to allocate the money you have into a long-term diversified portfolio.

One size does not fit all, though, and current allocation models are pretty simplistic.

You first must understand the reasons why you are investing. Are you building wealth for retirement? Are you seeking to retire early? Are you supplementing your income? That's why I suggest approaching all goals with the same strategy: Create and maintain a long-term diversified portfolio.

The longer your investment time horizon, the more risk is smoothed out. In addition, virtually all asset classes have positive returns over the long term while they do not necessarily have positive returns over shorter periods.

The reason for this is, over time, the economy grows, so earnings grow. Stock prices historically follow earnings growth. Corporate bonds are issued when companies are in their earnings growth phase, and growth leads to cash flow, which leads to most debt being paid off. Real estate becomes an increasing precious commodity as more and more land is developed, and so on.

Diversification is the first step towards effective asset allocation.

One reason for effective diversification is that it tamps down volatility. Different asset classes experience different degrees of volatility. Thus, those with less volatility will dilute the effect of those with more volatility. That leads to smaller standard deviations in a portfolio, that is, the extent to which returns will fluctuate from the mean.

The first reaction most people have to this concept is, "Doesn't that mean that I may have some downside protection in a bear market, but not enjoy the full upside in a bull market"?

All other things being equal, yes. However, this leads to the primary lesson of the discussion on asset allocation, and the overarching reason for effective asset allocation.

You want to avoid the permanent loss of capital

I would rather take part in most of the upside and miss some of the downside than capture all of each. However, I also said that our strategy includes maintaining a long-term diversified portfolio. That means re-allocating assets based on certain circumstances in certain asset classes so that more upside is captured in those asset classes without being exposed to riskier areas of the market.

How effective can diversification be? I've been investing for over twenty years. I've lived through many corrections.

The market fell 40% in 1987. My portfolio was down 24%.

The market fell 40% in 2000-2. My portfolio was down 25%.

The market fell 55% in 2008-9. My portfolio was down 33%.

Since I began investing, I have captured between 65% and 80% of the market upside. However, I've always slept well at night because my long-term diversified portfolio prevented the permanent loss of capital, while achieving my long-term goals.

That's not because I carried huge amounts of cash, although some times I were cash-heavy. Most of the time I are 95% invested, but I stuck to our convictions regarding our personal risk profile and what the market was telling us about risk.

Here is how I currently have my investment dollars allocated. This doesn’t mean you should do it the same way. It’s just where I am at this moment, with a brief explanation as to why. New investors may not be clear on some of these terms, but in the coming weeks, I’ll delve into each category in more detail.

Large Cap Stocks - Underweight. Large caps are seriously overvalued, especially as bond investors abandoned near-zero-percent yields to move further out on the risk curve to get dividends from so-called "blue chips"

Mid Cap Stocks - Overweight. Ignored as investors rush to large cap dividend stocks.

Small Cap Stocks - Overweight. Also ignored.

Growth Stocks - Underweight. Too much financial engineering is going on at many growth stock companies, elevating P/E's beyond anything reasonable.

Value Stocks - Overweight. I are value investors by nature, but find the crowd is rushing to the big-name expensive growth stocks.

International Stocks - Underweight. The world economy is struggling. China is not the growth engine some expected. Japan remains a mess. Debt is crushing most countries.

Emerging Market Stocks - Avoid. Same as international, but emerging economies are facing increasing levels of political instability.

Alternative/Private Investments - Overweight. While avoiding illiquid investments is difficult, private and alternative investments are emerging out a need for innovation in the face of increasing government regulation on legacy industries.

Real Estate - Regular weight. You must be extremely selective.

Utilities - Overweight. Low commodity prices mean utilities can spend less on them to provide them to consumers, enhancing earnings, while having government-guaranteed pricing.

Preferred Stock - Overweight. Despite many selling slightly above par, I see no competition from bonds in the next several years, and most preferreds have solidly solvent companies underneath them.

Muni Bonds - Regular weight. Good, low-risk returns are here, but I suggest avoiding municipalities run by less fiscally responsible left-wing governments.

Government Bonds - Avoid. They offer nothing in the way of yield and you can get higher yields with commensurate risk with preferred stocks.

Corporate Bonds - Avoid. While AAA-rated bonds are the only things I would touch, I believe exchange-traded debt and preferred stocks offer commensurate risk with higher returns. Avoid high yield corporate bonds.

Commodities - Underweight. I generally avoid holding commodities at all, but they are very cheap right now, and with decent upside compared to downside risk.

Cash - Overweight. I believe the opportunity to pick up large cap stocks and growth stocks may soon come around.