March 12, 2008, 7:00 am

The Principle of Asset Allocation Part1

by: The Financial Blogger    Category: Investment, Market and Risk
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It has been more than a year and a half that I blog and read other blogs on daily basis. I noticed that many of them would trade on their own and determine their own asset allocation according to their financial knowledge and experience with the market. I thought it would be a good idea to go back to the basic and review the concept of asset allocation.


I am personally starting to appreciate the full potential of this investment technique. This is a 2 parts series on asset allocation where I will discuss the pro’s and con’s of this concept.

As I already mentioned, I started trading about three years ago. I opened a line of credit; I maxed it out and started my adventure in the stock picking world. While I did well enough to build sufficient cash down for my first house, I lost all my profit the year after, just before buying my second house. What was the reason? I tried to make a homerun and I concentrated most of my asset in that hit. I ended-up with a strike-out.

The worst part is that I was following two mining stock and decided to invest in only one. While the one I bought dropped from $1.20 to $0.50 in one day, the other one went from $1.00 to $25.00 in a span of a year. If I would have put half of my 10K on it, my wife would have stop working by now! But I would not call this diversification or asset allocation.

A good asset allocation is done when you invest money a little bit everywhere (liquidity, fixed income, Canadian Equity, American Equity, International Equity) and that your allocation goes with your investment profile. Don’t buy only emerging market because you think it is hot right now. It is true that it is quite a good place to put your money but are you prepared to get a 18% drop tomorrow morning? This could definitely happen in this kind of investment.

I often look at people’s investment and I notice that they their asset allocation is not optimal. What does this mean? Some people may have a high aversion to risk and have 20% of their portfolio in small caps because they were told they would make good money with this investment. Others may be very aggressive and would not mind a drop of 10%-15% of their portfolio but they have 45% invested in fixed income and liquid assets. In this case, their advisor didn’t want to have any problems and decided to go on the safe side. In both scenarios, the client is always the loser.

In the part 2, we will discuss different ways to have an optimal asset allocation and how to determine your investment profile. You might be surprised to find out what your portfolio look like and what you should have in order to really meet your investment needs!

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Comments

Looking forward to post #2 – I believe that asset allocation is the most important aspect in investing. In research I have seen, asset allocation contributes to 70% of a portfolio’s returns while individual security selection makes up 30%.

The Dividend Guy

Got any thoughts about Dollar Cost averaging as a leveraging Strategy (DCA)? How does it compare to the strategy of borrowing money and servicing the interest through monthly dividends? As dividends as mostly provided by financial institutions and given the current economic slow down where shares of banks have fallen isn’t the latter strategy more risky?

G.Grover

by: The Financial Blogger | March 13th, 2008 (8:41 pm)

Raj,
If you are trying to “time” the market by leveraging in order to do a DCA, you might play a dangerous game. What if you are wrong and the market still goes down after you leverage?

Any leverage strategies should be considered over a period of minimum 10 years. If not, you are better off playing a the casino 😉

In regards to your second question, I would say that you should have enough cash flow in your budget to cover for the interest. The magic behind an investment loan is based on the marvelous power of compound interest. If you are withdrawing dividend from your investment instead of reinvest this money in the market, you will not benefit from the full power of this strategy. In addition to that, you are putting at risk your debt as you depend on a few high paying dividend companies…

Hope this helps!

FB.

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I enjoyed your post. Thanks for sharing it!

Best Wishes,
D4L

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I was reading your post on Government bonds. I ended up into this post on asset allocation. Bonds is a good investment when it’s part of your portfolio. Of course it depends of your investment profile.

Generally speaking, there’s a theory about the proportion of wealth invested in bonds and other type of investments as a function of the investors’ age:

For example, 25 years old –> proportion of 25% of your portfolio invested in bonds.
45 years old –> proportion of 45% of your portfolio invested in bonds.
etc.

What do you think about this theory?

Thanks again.

One Day,

I think it used to be a good rule of thumbs but this is not good anymore.

Imagine, I’m 27 and I should live until the age of 90. However, according to this method, I should already have almost 30% of my portfolio into fixed income…

I think that your asset allocation should be more related to your investor profile (i.e. risk tolerance) than your age 😉