What you are about to read flies in the face of everything your stockbroker or Wall Street adviser will tell you.
It’s about the closest thing to heresy you can get in the investing world… and the newsletter business. It’s also a key insight if you want to stay wealthy over time.
It is simply this: Stock picking alone won’t help you hold on to wealth.
Unless you are very lucky… or very, very talented… you will struggle to pick the right stocks at the right time ALL the time. You will make mistakes. You will mess things up.
And unless you have the right discipline in place, sooner or later you will lose money.
That discipline is called “asset allocation.” That sounds technical. But it’s really just about how you spread your wealth over different types of investments.
This is backed by hard data. In fact, there is just ONE thing that explains the difference between a good investor and a bad one.
For instance, a well-known study in 2000 by Yale professor of finance Roger Ibbotson and Paul Kaplan of Morningstar showed that differences in asset allocation among mutual funds explained virtually all of the variance in their returns.
Differences in stock picks made virtually no difference to the variance in portfolio returns.
Common Sense Decisions
It’s common sense, but you don’t put 100% of your wealth in stocks in a savage bear market.
And you don’t invest 100% of your wealth in bonds in times of runaway inflation.
This seems straightforward. But you’d be surprised how many investors skip over these fundamental decisions in the rush for the latest “hot stock.”
This is nearly always a bad idea.
Before you even think about picking which individual stocks to own, you have three decisions to make. These are the three most important decisions you make as an investor.
1) Which assets to hold in your portfolio
2) In what proportions to hold them
3) When to change those proportions
Get these three decisions right, and long-term wealth creation and preservation will follow. Get them wrong, and you are unlikely to hold on to what you’ve worked hard to earn and save.
So what makes for a good asset allocation?
Today, I’d like to share with you what we’ve learned so far at Bill’s family wealth advisory service, Bonner & Partners Family Office… where our goal is long-term wealth preservation.
7 Rules of Successful Asset Allocation
1) It will have a cash buffer – Having cash on board makes it easier to deal with a major downturn and the losses that come with it. Remember, you want to make sure you are not forced into dumping your investments in times of market stress.
The more cash you hold, the more of a buffer you have. Having cash on board also allows you to go bargain hunting when investments go on sale. In times of crisis, having enough cash to buy beaten-down assets is essential.
2) It will be an inflation beater – Your asset allocation must allow you to stay ahead of consumer price inflation. There is little use in putting together a portfolio that gets eaten away by inflation.
This is especially important given the sky-high deficits most advanced economies are running and the widespread money printing central banks are engaging in. We may not see a lot of inflation show up now. But that doesn’t mean it won’t show up in the future.
3) It will be able to withstand currency depreciation – This is particularly important if you are internationally mobile, as many Bonner & Partners Family Office members are.
There is no point in making big portfolio gains in a currency that is losing value. Or for that matter, leaving a portfolio vulnerable to the collapse of a currency (something that is now being talked about openly in the case of the euro).
4) It will be properly diversified – A prudent long-term portfolio will contain a mix of asset classes that reduce risk. It will also be well diversified within asset classes.
For example, the money you have in stocks should be diversified across sectors and geographies. Having all your stock market investments in Japanese nuclear stocks, for example, is a bad idea, even if you have only 10% of your total wealth invested in stocks.
5) It will take advantage of the “bargain counter” – The individual assets you own should only be bought when they are selling at what we like to call the “bargain counter.”
If you buy when an asset is expensive you expose your portfolio to the risk of a large capital loss. Buying assets when they are selling at a discount to their estimated fair value increases your margin of safety.
6) It will follow sensible “position sizing” rules – Position sizing answers the question “How much should I own?”
The answer to this question varies. But as a general rule, never put more than 3% of your overall capital at risk on one stock position. This is one of the most effective ways of reducing the risk of a ruinous loss to your portfolio.
7) It will contain plenty of “off market” assets – “Off market” assets are assets that don’t trade on a public exchange… things such as real estate, gems and stakes in private business ventures.
Putting all your money at risk in the financial markets (whether in stock markets, commodity markets, bond markets or currency markets) is too much of a risk.
For instance, owning a quality house… bought at a good value and soundly financed… is an excellent way of reducing overall portfolio risk. If you go about it right, you should own the home outright by retirement.
Owning a home debt free is one of the best protectors against financial crisis that there is. Owning a private business or investing in one is another great way to earn high returns on your capital.
The Icing and the Cake
Asset allocation is how serious investors think about investing.
At Bonner & Partners Family Office we call the returns you get from your asset allocation decisions “beta.”
Beta is the result you get from getting the big trend right.
Once you’ve got your beta right, it’s time to look at boosting those returns. We call this “alpha.” Alpha is what you get by choosing the individual investments (stocks, bonds, etc.) best positioned to profit from the big trends.
Beta is the cake. Alpha is the icing on the cake.
The most important wealth secret you’ll ever learn is understanding this relationship… and always starting with the cake first.
Most investors get this backward. And they suffer as a result.[Ed. Note. Chris started his career as a commodities and energy analyst for the global financial news agency Reuters. He also worked as an investigative reporter during the Celtic Tiger boom in his native Dublin. Chris later realized it was more lucrative to apply his investigative skills to the markets. He has been working as a financial analyst with Agora since 2007. He now splits his time between Buenos Aires and Berlin.]