What Is The Best Asset Allocation Strategy?

By Joe Ponzio on February 8, 2008  |  11 comments

A common question among investors — both conventional and non-conventional — is: How should I allocate my portfolio so I am best prepared to capitalize on (or protect myself from) the coming years in the markets? Mutual fund, which were designed to, in part, shield people from volatility, aren't living up to their promises and even "well-diversified, long-term" mutual fund investors are finding it difficult to "stay the course" like their advisers instructed.

Here's how to do it.

If you are new to F Wall Street, allow me to present to you the four types of investors that are striving for long-term growth:

1. The general conventionalist is looking for long-term, steady growth and can not, or does not want to, stomach the stock markets. 50% of the population falls into this category.
2. The enterprising conventionalist is also looking for long-term growth but is willing to tolerate minor fluctuations in stock prices. 35% of investors are enterprising conventionalists.
3. Safety-seekers can tolerate market fluctuations...to a point. Daily and minor fluctuations are largely irrelevant; large price changes are still gut-wrenching. >14% of investors are safety-seekers.
4. Non-conventionalists could care less about market or price fluctuations and look to find value and opportunities in every market. <1% of investors are non-conventionalists.

Though each of these investors can achieve satisfactory results over the long run, their psychologies will greatly affect how they should be invested.

The General Conventionalist Portfolio

You do not have to be "in the markets" to grow your money. Mutual funds are not your solution. Consider investing your entire portfolio in investment grade bonds, preferably laddered in 10-year increments. Don't be afraid to venture into secure foreign bonds if US rates are too low (e.g., at the time of this writing, the 2-year Australian government bond is yielding 7.5% and matures in September of 2009 — a potential candidate as you build your portfolio).

Stuck investing only in your 401(k), with no bond selection? Folks, this is your livelihood. You have to beg your employer or human resources department to give you a better selection or consider hiring an independent 401k provider to manage your plan.

Over the past 40 years, the general conventionalist could have earned nearly as much as a stock market investor with virtually no risk and very minimal volatility. If the markets have you tossing and turning or you are worried about putting money in stocks right now, you are probably a general conventionalist.

Expected return: 7-9%

The Enterprising Conventionalist

Would you feel "safe" having some of your money in stocks if those stocks were, say, Coca-Cola, Wal-Mart, Walt Disney, and General Electric? You know, "boring" stocks that pay dividends and don't move "too much"? If so, you are probably an enterprising conventionalist. As such, you should consider putting 50% of your portfolio into a bond ladder (as discussed above) and 50% of your portfolio in large companies that pay dividends.

When looking for these companies, consider sticking with large, household names. Buy them when they are on sale (cash is fine when they are not) and put them on the shelf. As you add money to your account, split it between the bonds and the stocks. For you, 8-10 household names may be enough.

Enterprising conventionalists may want to consider reinvesting dividends and should strive to balance their accounts by adding the stock portion of new contributions to the smallest positions based on their percentage of the whole. (e.g., if nine of ten stocks add up to 93% of the stock portion, then each of those nine is 10.3% of the stock portfolio and the remaining stock is just 7%. In that case, consider buying the tenth stock.)

Expected return: 8-12%

The Safety-Seeker

Think bonds are too conservative and boring? Would you be content beating the markets by one or two points, on average, over the long-term? Gut-wrenching markets still make you somewhat sick? You, my friend, are probably a safety-seeker.

Safety seekers should also consider a 50/50 split in their portfolios. The "boring" part should be invested in much the same way as the enterprising conventionalist's stock potion; the remaining half can be divided in a more non-conventional way (below). The safety seeker should never use margin and should keep workout opportunities to a maximum of 5% of his or her portfolio.

As a safety-seeker, you should probably avoid companies with market capitalizations under $500 million simply because the volatility generally associated with smaller companies can really shake your nerves and cause you to make emotional, rather than business, decisions.

Keep in mind: There is no shame in being a safety-seeker. In my book (to be published by Adams Media), you'll hear the story of a safety-seeker who, starting with just $10,000, amassed a $1.4 million fortune as an at-home mother with kids in high school and medical school.

Expected return: 12-15%

The Non-Conventionalist

The non-conventionalist watches the markets only to the extent that he or she is looking for opportunities. For these investors, the Dow at 14,000 was growing increasingly boring; the Dow at 12,000 or 10,000 is delicious. Non-conventionalists have an appetite for business and have trouble sleeping when the markets are crashing because their minds are replaying the day's annual reports and workout opportunities.

Non-conventionalists never buy hoping to make good sales at a later time; they buy when they can get substantially more value than that for which they are paying. They know that the markets will eventually reward them for their good decisions and they accept that the ultimate timing and amount is out of their hands.

If you are a non-conventionalist investor, you may consider investing 80% of your assets in long-term, undervalued companies and up to 30% in workouts. I know — the math doesn't work. Non-conventionalist investors use margin (though sparingly) so that, when great opportunities come along, they can invest $11,000 for each $10,000 in their account — or 110% of their assets.

The 80% portion should be diversified. That is, the non-conventionalist investor should consider having between three and eight companies. Because they put their money where they are offered the most value, non-conventionalists need not hold more than the very best opportunities.

The 30% workout portion should also be split amongst a wide variety of opportunities. Depending on your portfolio value, you may have as few as none and as many as fifteen workouts at any given time. The actual amount, of course, depends on how much value each workout is offering. (e.g., the Tribune workout was my only workout at the time and I had a full 30% of my assets in the position).

Expected return: >15%

The Non-Conventionalist Approach to Buying

Buying workouts is fairly straightforward. To lift a bit from Benjamin Graham, if, upon thorough analysis of the deal, you see an opportunity for both safety of principal and a satisfactory return, you should buy. The greater the opportunity (for both return and safety), the more you should buy.

When approaching businesses, you should have a definite price in mind. Then, you should begin buying in 10%-20% chunks — once a week or so. That is, if you plan to commit 20% of your portfolio to a particular opportunity, begin buying in 2%-4% increments over five to ten weeks. This serves two purposes: (1) it allows you to capitalize even more if the price continue to drop, and (2) it prevents you from guru-itis, the belief that you are always right and everyone else is always wrong. (You will be wrong from time to time.)

Come on Joe, I'm not working with millions here!

How much is enough? Assuming you are putting 10% of your portfolio into each opportunity, that you intend to buy over five weeks, and that you pay an average of $10 in commissions for each trade, a non-conventionalist investor should have at least $50,000 so that no single transaction costs more than 1% of his or her investment.

If you are working with less than $50,000, then you'll have to make some sacrifices. Your purchases will have to be made over just two or three weeks or in a single transaction. You'll be forced to engage in less workouts and have to be much more careful in your selection.

Still, don't be disheartened if you currently have just a few thousand dollars. Put money aside every month and keep in mind that my kids collectively own just two stocks as I build their portfolios. For them, workouts are out of the question right now. I hope they each have 80 years of investing ahead of them so I'm not concerned with capitalizing on every opportunity I see today. The next 80 years should present a few more.

A Final Note/Disclaimer

The "Expected return" assumptions above assume that the next forty years are substantially the same as the last forty. That is, through wars, recessions, high and low federal funds rates, elections, housing booms and busts, tech bubbles, inflation, deflation, leveraging, deleveraging, and salad oil scandals, our economy and country will survive. If I'm wrong, your money will be worthless, all the stocks and bonds in the world won't save you, and the General Conventionalists buying Australian bonds will look like geniuses!

Also Filed Under "How to Think About Investing"

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