The Most Important Investment Decision You’ll Ever Make

The most important decision you will make as a long-term investor is how much of your wealth to invest in stocks, bonds, real estate, cash, commodities, and precious metals. A look at the Vanguard Group monthly returns for 518 U.S. balanced funds from January 1962 through December 2011 concludes that asset allocation, not stock picking or market timing, explains the vast majority of a portfolio’s returns over time. But that’s not how most investors behave…

The average small investor does not have an asset allocation strategy. Instead he owns a chaotic mix of stocks and funds, most often recommended to him by his broker, his friends, or the talking heads on TV.

But here’s the thing… Unless you are very lucky… or very, very talented… you will struggle to pick the right stocks at the right time all the time.

Don’t get me wrong… Building wealth over time purely through stock picking is possible if you are Warren Buffett or George Soros, and you have a track record of years of high performance.

But the sad truth of the matter is that the average investor doesn’t beat the markets. The markets beat him.

For example, take a recent study by America’s leading financial services market research firm, Dalbar. It revealed that, although the S&P 500 returned, on average, 10% a year over the last 30 years, the typical stock market investor earned average annual returns of less than 4%.

The average investor’s stock selection and market-timing decisions left him with half the returns of a simple index fund.

A Very Special Meeting…

Once a year, in a gentlemen’s club in the city of London, overlooking the Thames River, I attend a meeting of the representatives of some of the oldest and wealthiest family offices in Europe.

Over three days, we discuss investing and wealth preservation strategies. And I can tell you that nobody in the room believes you can make and hold on to real money over time purely by trying to pick the right stocks at the right time.

Most family office investors – whose goal is to preserve wealth over generations – don’t pick stocks at all. If they decide to invest in individual stocks, they usually leave the decision making to a third-party fund manager.

So what do they do if they are not picking stocks?

Family offices spend huge amounts of time and energy deciding when they should buy stocks… bonds… commodities… and real estate… and how much of their total wealth should be invested in these asset classes at any given time.

In other words, before you even think about picking what individual stocks to own, you have three decisions to make. These are the most important decisions you make as an investor:

1)  Which assets to hold in your portfolio

2)  What proportions to hold them in

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.

We call this “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 (if possible). We call this “alpha.” Alpha is what you get by choosing the stocks best positioned to profit from the big trends.

Beta is the cake. Alpha is the icing on the cake.

7 Secrets to Successful Asset Allocation

The secret to successful investing is understanding this relationship… and always starting with the cake first. Most investors get it backward. And they suffer as a result.

So what makes a good asset allocation? What we’ve learned is that it must meet seven criteria:

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. As our strategic partner in the resource sector, Rick Rule, puts it, “Cash equals bullets.” 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 by central banks.

You may not see a lot of inflation 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 the overall risk of drawdowns.

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 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 veteran market observer and Dow Theory Letters editor Richard Russell calls 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 precise position sizing rules – Position sizing answers the “How much should I own?” question. 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, 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 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.

In fact, owning a home debt free is one of the best protections 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.

Conclusion

Asset allocation isn’t as “sexy” as stock picking. And it’ll bore the heck out of folks at dinner parties.

But ask yourself if you are in the top 1% of investors worldwide. If not, you are going to have to focus on something other than stock picking to generate the returns you are looking for.

The best way to do this is through asset allocation.