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April, 2006


The question of whether or not to allocate one's hard earned assets within different categories can boil down to how much risk one is willing to take for the desired investment objective. In the last bear market, from early March, 2000, through October, 2002, the Standard and Poors 500 Index of large-capitalization stocks lost roughly 36%.

A well allocated set of assets (such as was suggested here in early 2001: Getting Rich Slowly - In Defense of Diversification) would have lost only about a third as much in the same period, while still providing overall good potential for growth.

The diversification recommended in the cited essay would have resulted in a total loss of about 13% in the worst 2-year period of that bear market, 2001-2002, while still retaining a compound annual growth rate of about 10% through the 15+ years from 1/1/91 through 4/13/06.

While a 100% investment in the S&P 500 Index over that same 15+ year span would have provided a better compound return, roughly 11 1/2% a year, it would have been at the cost of much greater volatility. Between 12/31/00 and 12/31/02, for instance, investment of all one's assets in the Vanguard S&P 500 Index Fund (VFINX) would have delivered a total loss of over 31%, more than 22% in 2002 alone. An investor with $100,000 on 12/31/00 would have had roughly $68,500 on 12/31/02.

The story was even worse for US equity markets as a whole, which lost about 40% (37% if dividends are included) between 12/31/99 and 12/31/02, as measured by the Vanguard Total Stock Market Index Fund (VTSMX). Even including dividends, $100,000 at the end of 1999 would have been worth only about $62,600 by the end of 2002.

Since late 2002 or early 2003, the US stock market has risen substantially, with some indexes now approaching new highs and at their best levels in several years. In fact, we have now gone over three years since a significant market correction. I understand there have only been a few prior times when this long a period has elapsed without a 10% or greater correction. I believe in each of the other instances such a period was followed by market pullbacks of from 10-40%. While this time may be different, I think it particularly prudent now to assure that one's assets are well allocated.

Just as has been true earlier, it is quite possible that concentration in just one asset class or another, for instance real estate, stocks (or stock mutual funds), or commodities (for example, precious metals), will continue to provide good returns with adequate safety or will even exceed other asset categories for awhile further. However, there is also a substantial risk that one or more of them will fall by a large amount in the coming months or years.

Each investor must decide for himself or herself what is an acceptable level of potential volatility for a preferred level of return. Under conditions such as currently prevail, Benjamin Graham, in The Intelligent Investor, would likely have recommended no more than a 25% investment in stocks or stock mutual funds, with most of the balance in cash, short- to medium-term bond assets, or real estate.

A similarly prudent approach to real estate investing at this time might call for no more than 25% of one's income from all sources being paid out in mortgage, taxes, insurance, or other fees directly related to real estate ownership. If the outlay is presently more, then the suggestion would be to either increase income or sell real assets until the 25% threshold is not exceeded.

But I understand that for individuals who are very familiar and comfortable with the prospects and risks involved in an asset class, such as equities or real estate, a higher than recommended percentage of one's net worth might be maintained in the category in question. In a few cases, there might even be a market situation that is as close to a sure thing as possible, and then it would be foolish to dump an asset just to assure some rigid and conservative allocation guidelines are met.

With commodities, particularly precious metals, even if they are held as a hedge against inflation or setbacks in other markets (for example, precious metals often do well in times of financial uncertainty, when there are fears of unpleasant things: severe political disruptions, big losses from a natural disaster, a substantial rise in the price of oil, possible war with another country, the potential for new acts of terrorism, etc.), the usual recommendation is that they not be more than about 5-10% of one's total holdings, since they are so volatile themselves and often do not offer much investment value other than to offset losses in other categories.

I personally am not comfortable with options or with selling stocks short, but some find such measures to be worthwhile types of speculation when stocks are fairly high. But there is always the possibility stocks will go much higher still. I have heard that investment money manager and columnist Ken Fisher thinks US stocks will go up a very significant percentage this year. Perhaps he has a crystal ball.

Other factors in the overall equation of what amount to have in one category or another are how large and how safe one's other income sources are. A person receiving a monthly annuity from a very reliable source, Social Security for instance (considered safe at least for the next several years), might count that income as if it were provided by a conservatively allocated bond portfolio. Seen this way, $10,000 a year of assured income might be the same as having an extra $200,000 invested in bonds. So one could then count that much toward a non-equities allocation.

Thus, there are a variety of considerations when coming up with the right diversification. One wants enough of both risk and reward to attain one's realistic goals, yet without much chance of long-term loss of funds. I encourage folks not really sophisticated in the field to see a reputable financial planner, preferably one who works on a "fee only" rather than a commission basis.

While it is just an illustration, and each person's situation is different, for the basic, all markets' cookie-cutter approach, everything else being equal and assuming one's debts are under control and that one does not have too high a vulnerability to local market changes in real property values, I still like the allocation of one's liquid assets suggested in that previous essay, so long as it will be rebalanced periodically: 10% in money market accounts or other cash equivalents; 30% in bonds or bond mutual funds; and 60% in stocks or stock mutual funds (if one will not need to depend on the sale of such volatile assets in the near- to medium-term).

My brother, Frank, a financial consultant and brokerage office manager, suggests that liquid assets be rebalanced after a 10% up or down change in the markets. That works for me, and by that criterion, in view of the strong overall equity market performance since 2002 (S&P 500 total return 12/31/02-4/13/06: up 70%), if one has not reallocated one's financial resources in the last few years, it is definitely time to do so.

By rebalancing, it is simply meant that if one or another of the preferred allocation percentages has risen or fallen significantly, it should be reestablished by the sale or exchange of assets/proceeds from the higher than intended category and addition of the required amount to the category or categories that have fallen below their intended percentages.

Using our example from the linked investment essay in 3/01, at that time, the three categories (money market fund, bond index fund, and S&P Index fund) had last been rebalanced to their ideal percentages (10%, 30%, and 60%, respectively) effective 12/31/00.

Given that the S&P 500 Index had fallen by over 10% in 2001 and again in 2002, there should have been a rebalancing in each of those years, restoring the 10/30/60 percent levels for the cash equivalent, bond, and equity funds. In the process, the relatively well performing bond assets would have been sold when high, while the under performing equities would have been bought at bargain levels.

Thus, when the S&P 500 Index had surged back in the 2003 through 2006 period, that 70% gain over the period would have generated several rebalancing opportunities when equities in their turn would have been sold while high.

In this way, the fundamental investment maxim, to "buy low and sell high" would have been followed while also maintaining the relative safety of a well allocated portfolio.

At first glance it might appear that nothing would have been gained through such successive purchases and sales. After all, one had simply bought and sold to restore a balance among the types of investments.

But in fact, since the purchases would tend to be lower than the market averages and the sales to be higher, one would have been profiting by both the market's natural tendency to go up over time but also by the differences between the lower buy and higher sell prices. In this way the average performance of the bond and equity portions of the portfolio would gradually have been a little greater than for the market as a whole. Instead of the 10% a year average gains of the portfolio that had been rebalanced only occasionally, the assets that were rebalanced each time the market were up or down ten percent or more might well turn out to have been up 11% or so on average, and so been even more competitive with the much more risky buy and hold equity-only portfolio.

In the current situation, then, I again recommend that one assure a well balanced set of assets, in the percentages with which one is comfortable as to both risk and potential reward. Then one will be ready for whatever the market does in the balance of the year. If equities continue to surge, as Ken Fisher suggests, it will be easy to calculate how much to then exchange out of the S&P 500 Index Fund, raising the levels of the money market or bond fund accordingly. But if they dip substantially, one can also easily calculate how much to raise the equity portion at the expense of the money market or bond categories.

In the presently very uncertain time, a variation on the simple 10/30/60% allocation approach which may turn out to be helpful would be to put 5-10% into precious metals and then maintain that category within a 10% tolerance as well. This may be done by either buying individual precious metals stocks or investing in a good mutual fund that holds such assets. I would make the change gradually, perhaps with a small purchase each month for a year or so, since this will lower the risk of entering an asset category that has already had a good run and is at a relatively high level now.

Once finished, the new portfolio allocation might look like this:

  • 10% money market mutual fund (s)
  • 10% precious metals mutual fund(s)
  • 25% bond mutual fund(s)
  • 55% S&P 500 Index mutual fund(s).

As before, when there is a 10% or greater up or down change in the market or the portfolio category(ies), it would be time to rebalance.

Although we generally use individual stocks rather than mutual funds, otherwise (apart from real property - mainly our residence - or a few collectibles) we lately have been employing an allocation arrangement similar to that just above, since it seems a number of things may keep overall market conditions and current events rather in limbo for awhile, and precious metals assets tend to do better under such conditions. Indeed, this portion of our portfolio has risen substantially in the last several months. Yet, though we too are rebalancing periodically and so restoring the intended precious metals level, we are not selling all of such assets because the reasons for adding them to the portfolio in the first place appear to remain.

A final example takes yet another approach to diversification. Had investors held equal initial parts (20% allocation each) in five asset categories (as through exchange traded funds, Vanguard funds, Fidelity, etc.) and rebalanced annually, they might have seen fairly steady growth in total assets (right through the big bear market, except for a slight dip in 2002) and received a roughly 12% average compound annual total return over the ten-year period ending 12/31/05, and an about 9% compound annual return during the last five years (with yet another jump in performance since then, so far in 2006). The five categories are:

  • small-cap value
  • large-cap value
  • real estate investment trusts (REITs)
  • S&P 500 Index
  • small-cap market index.

The year-end values of $100,000 would have looked like this (plus or minus a little, depending on the management fees and commissions of the assets chosen):

Year        Value of 5-Category Investments
         (including dividends)
1995         $100,000 (begun)
1996         $123,727
1997         $159,051
1998         $173,422
1999         $176,818
2000         $209,295
2001         $211,491
2002         $208,178
2003         $245,042
2004         $294,169
2005         $316,391

(As always, past performance is no guarantee of future returns, and one is advised to check with a financial consultant and/or do one's own research prior to any investments.)

For more on the historically best performing, low risk portfolio allocations, we can recommend a membership in the American Association of Individual Investors - AAII.


Larry is not a professional. Don't take him seriously!

Actually, the investment article provided here is for general information only and should not be considered as professional advice, a solicitation to buy or sell any security, or the Word of God. Investors are encouraged to do their own research while considering their personal goals and circumstances, or consult their own professional financial advisors, before making investment decisions. Neither Larry nor LARVALBUG will be liable for any losses sustained by any visitor to this site.

(Disclosure statement: Larry and Val have holdings in some of the suggested assets but do not "make a market" in any of them and do not derive any direct benefit from recommending them, except perhaps for a bit of smug self-satisfaction.)

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