This is a Guest Post By Brian Hunt CEO of InvestorPlace.
Imagine you’re taking cross country road trip. You and a friend will drive from New York City to Los Angeles… and see lots of sights along the way.
Let’s also say that you’ll buy a new car for the drive.
I think you’ll agree that on a trip that long, a car’s comfort and reliability are critically important. You don’t want to get a back ache by the time you reach Illinois… and you don’t want to break down in Oklahoma.
You’ll probably also agree that the quality of the car’s stereo system is of secondary importance to the car’s reliability. Even with an average stereo, you can make the trip just fine. You and your friend can talk.
When it comes to reaching your goals as an investor, this road trip contains an important lesson. That’s because when it comes to investment success, asset allocation and stock picking are like your car’s reliability and your car’s stereo.
Asset allocation is 100 times more important than stock picking… and knowing how to practice intelligent asset allocation is one of the most important investment concepts you’ll ever learn.
This essay will show you how to harness asset allocation’s enormous power.
How Asset Allocation Works
Asset allocation is the part of your investment strategy that dictates how much of your wealth you place in broad asset classes like stocks, bonds, cash, precious metals, and real estate.
Over the course of your career as an investor, asset allocation will have a much, much greater impact on your wealth than will stock picking. Again, the ratio will be at least 100 to 1.
Since most individual investors spend their time trying to find the best stocks to buy, they don’t spend any time learning what sensible asset allocation is… and take crazy risks with their retirement savings.
The most important aspect of asset allocation is using it to diversify your holdings across private businesses, public stocks, real estate, precious metals, cash, insurance, and other financial vehicles.
Ideally, you want a diversified mix of assets that greatly limits your exposure to a big decline in one asset class.
Intelligent asset allocation means you DON’T bet the farm on a single stock or a single asset class.The Asset Allocation Hall of Shame
For example, you may be familiar with the catastrophic losses suffered by some employees of Enron.
In the late 1990s, Enron was considered the world’s most innovative company. Its executives were the superstars of corporate America. So, some Enron employees placed all their retirement savings in Enron stock. Their asset allocation was “100% Enron.”
When Enron was revealed as one of the biggest frauds in American history, its stock went to zero. The employees who bet the farm on Enron were completely wiped out. These people became victims of their own absolutely horrible, incredibly risky asset allocation.
Or, consider people who went “all in” on real estate in 2005 and 2006.
Back then, the U.S. real estate mania was in full force. Real estate was considered a “can’t lose” bet. So, many people put all their savings into real estate… and even took on loads of debt to “leverage” their returns.
When the real estate market crashed, these “all in” real estate players were wiped out.
At the heart of their downfall was totally stupid asset allocation.
They bet the farm on one asset class that was in a bubble.
Also, realize that if you get your asset allocation terribly wrong and go 100% into the stock market when it is extremely popular and expensive (like it was in 2000), stock picking will not help you.
Most every stock you buy – no matter how good it sounds – will turn out to be a losing investment for a long time. As we’ve detailed in other essays, you can make a terrible investment in a great company if you pay a stupid price.
If you keep a huge portion of your wealth in a single asset class – whether it’s stocks, bonds, oil, gold, real estate, or whatever – you leave yourself exposed to a large decline in the value of that asset class. You make yourself financially “fragile.” You leave yourself vulnerable to what happens with that one business, market, or asset class.
Is it Time to Change the Game You’re Playing?
Now, to be fair, most fortunes are built with big bets on one single business – called “concentrated bets.”
But if you’ve “won the game” and built up a substantial amount of wealth with a concentrated bet (like a lucrative private business or a lucrative career), you’ve actually started a new game.
It makes sense to climb down a few rungs on the risk ladder and focus on “preserving” your wealth through intelligent diversification instead of “building” wealth with an aggressive (and risky) concentrated bet.
There’s no “one size fits all” asset allocation strategy that is right for everyone. When you (possibly with the help of a financial advisor) think about your right “mix,” you must consider your age, risk tolerance, cost of living, and financial goals. A 55-year old who wants to pay college tuition for three children will think about asset allocation much differently than a 32-year old with no family.
However, most of us have a similar end goals. We want to own a diversified collection of assets that throws off lots of income… even when we are not actively working. We want to buy high quality assets for bargain prices… and make “once decision” financial moves we don’t have to change for decades. We want our financial empire to be crisis-proof and inflation-proof.
Again, having all that means being diversified across private businesses, stocks, bonds, real estate, cash, precious metals, and insurance. It means NOT risking it all on one single company or stock market.
A Great Asset Allocation Discovery
There are many well-known asset allocation strategies that can provide you with excellent diversification.
Some of them come from brilliant financial minds like hedge fund managers, Ray Dalio and Rob Arnott.
Most of the commonly-used strategies recommend owning a mix of assets like U.S. stocks, non-U.S. stocks, government bonds, gold, real estate, commodities, and private business.
It’s not uncommon to see a recommended asset allocation with a moderate risk-tolerance to be 30% – 40% in stocks… 10% – 20% in real estate… 20% – 30% in bonds… and 10% – 20% in commodities and gold. The percentages vary from model to model… and depending on the investor’s age.
It turns out, if you get the basic idea of “diversification” right, the fine details don’t matter much.
Our friend, Meb Faber, is a master of using computerized analysis to evaluate investment and asset allocation strategies. In 2013, Meb performed a comprehensive study on how various asset allocation strategies have performed over the long-term.
Meb discovered there isn’t much difference in the long-term results of the best strategies. The returns of these asset allocations – though very different in construction – all posted long-term returns that were in the same general ballpark.
But Meb’s study did reveal something that greatly influenced returns…
Meb found the amount of fees investors pay to own investments has huge effects on long-term performance… a much larger impact than the specifics of any given strategy.
Meb’s findings are stunning to many people. He found that fees, not specific asset mixes, have the largest effect on investor returns. In other words, get a good general asset allocation… and then focus on driving your investment costs and fees into the basement.
We highly recommend Meb’s book Global Asset Allocation: A Survey of the World’s Top Investment Strategies. If you’re interested in learning more about the critical importance of keeping your investment fees low or picking a “set it and forget it” asset allocation, Meb’s book is a great resource.
Let’s come full circle…
Prior to reading this essay, what was your take on asset allocation? Did it play into your investment decisions at all? Or might you have considered yourself only a “stock picker?”
If your answer is the latter, we hope you now understand the shortfalls of such an approach.
Over the course of your career as an investor, asset allocation will have a much, much greater impact on your wealth than will stock picking. The ratio will be at least 100 to 1.
To repeat for emphasis: The most important aspect of asset allocation is using it to diversify your holdings across private businesses, public stocks, real estate, precious metals, cash, insurance, and other financial vehicles.
Intelligent asset allocation means you DON’T bet the farm on a single stock or a single asset class.
Please take a look at your own mix of investments. If you’re betting the farm on just one stock or real estate deal, consider making a change and getting to safer ground.
You can see more work by Brian at InvestorPlace.com.