Is Your Portfolio in PEAK Condition?
Functional Asset AllocationTM
Michael Beer, CFP®
Fee-only Personal Financial Advisor
Founder - PEAK Advisors
Registered Investment Advisor
mabeer@peakadvisors.com
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Is Your Portfolio in PEAK Condition? Functional Asset AllocationTM |
Michael Beer, CFP® Fee-only Personal Financial Advisor Founder - PEAK Advisors Registered Investment Advisor mabeer@peakadvisors.com |
"Let every man divide his money into three parts, and invest a third in land, a third in business, and a third let him keep I reserve." |
| -Talmud Circa 1200 BC-500 AD |
| The quote above is approximately 2000 years old. Whoever said it certainly new something about risk. He also knew something about return. Asset allocation, as we're so fond of calling it today, is really just a new twist on a very old and very successful investment strategy - diversification. It's the reason we learned about the Niņa, the Pinta, and the Santa Maria in grade school. No King or Queen worth their salt would allow treasure to sail in just one ship. A contemporary translation of the Talmud quote might read: "Let every investor create a diversified portfolio allocating one-third to real estate investments, one-third to common stocks and one-third to cash, cash equivalents and bonds." My translation would be keep one-third in your pantry, one-third in your garden and one-third in your cash crop. (More on that later) | ||||||||
| Modern Portfolio Theory (MPT) , on which most asset allocation is based, focuses on diversification across asset classes in an attempt to reduce the volatility of a portfolio. Investment managers identify from six to twelve asset classes (and sometimes many more if you consider sub-classes) and then use computer models to generate the a mythical creature known as the "efficient frontier". | ||||||||
| In my formative years I was classically trained as an economist at the University of Michigan so for me this efficient frontier is a very interesting thing. Any point along the efficient frontier theoretically provides the exact mix of assets that will provide the highest rate of return with the least amount of risk. Its pretty cool stuff, Harry Markowitz won a Nobel Prize for thinking it up. Modern Portfolio Theory relies heavily on the Law of Large Numbers. The Law of Large Numbers is very useful for large Pension managers, insurance actuaries and state lotteries but it in no way is beneficial for you and me when determining what course of action to take because we just don't have enough zeros in our portfolios for it to work (For a discussion of why click here). It is completely and totally useless, an exercise in futility, a total waste of time when it comes to developing your portfolio. | ||||||||
| Sadly, this industry is filled with well meaning but misguided investment advisors, insurance agents and registered representatives who are trained to believe MPT is gospel and Harry Markowitz is the Apostle Paul. This is where we get the "rules-of-thumb" touted by and taught to so many that espouse things like, "Subtract your age from 100 invest that much in equities and the rest in bonds". Nonsense. Ironically, Mr. Markowitz never intended his beautiful model (and I say that with all sincerity) to be used by the individual investor. He understood that in wouldn't work on that level. Fortunately, Functional Asset AllocationTM does. | ||||||||
| Functional Asset AllocationTM (FAA) is the brainchild of Bert Whitehead J.D., CFP®. Bert realized that the success or failure of an individuals investment portfolio depended much more on what was going on in an investors life (the endogenous factors) then it did on the state of the economy and other world events (exogenous factors). This is precisely the reason MPT not only doesn't work, but also imparts a level of danger when mechanically used to construct your portfolio, because MPT does not take into account your unique situation. It was never designed to. Mr. Whitehead also realized that far more important then using asset classes for their statistical properties was to use them for their functional purpose. | ||||||||
| The driving force behind FAA is your unique situation and the endogenous factors that define you. Each of the three broad asset classes we use: Interest Earning, Real Estate and Equities has a specific function. I often refer to them as the pantry, the garden and the cash crop. | ||||||||
| Interest Earning: The Pantry: Function: Capital Preservation | ||||||||
| Interest Earning consists of two broad asset classes (Cash and Bonds) and serves the purpose of Capital Preservation. I want to make sure that clients have adequate cash flow, regardless of what happens in the financial markets - and in their lives - in order to maintain their standard of living for a given period of time. In the early stages of the Financial Life Cycle, I have clients accumulate enough in this asset category to provide six to twelve months of liquidity, before making long-term investments. In later stages of life, formulas are structured to provide a sure cash flow for ten, twelve or even fifteen years. The appropriate attention to Capital Preservation in each stage gives clients peace of mind when they follow these recommendations. To assure maximum tax efficiency, I recommend using primarily retirement assets to fund this category, except for the amount needed for day-to-day liquidity. The pantry is where you go when you need something now. It is where you go when things are sparse in the winter. It's where you go when the cash crop fails. | ||||||||
| Real Estate: The Garden: Function: Personal Use and Enjoyment | ||||||||
| Real Estate is divided into three asset classes: Personal Residence, Productive (including REITs and rental property) and Non-Productive (such as vacant land, second homes and passive limited partnerships). The unique functions of real estate include personal use and enjoyment and the opportunity to leverage by mortgaging the property. Positive financial leverage through a home mortgage provides Americans with the most advantageous after-tax investment vehicle in the world (particularly with the changes brought about by the Tax Reform Act of 1997). This is why I place so much emphasis on this asset category relative to what most investment managers recommend. Real estate, just like a garden, may be used to help stock the pantry or provide an income, but its primary purpose is enjoyment. | ||||||||
| Equities: The Cash Crop: Function: Growth | ||||||||
Equities include four asset classes:
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| If Functional Asset AllocationTM is so wonderful, why isn't everyone doing it? There are three primary reasons. First, investors lack awareness of the power of diversification. The typical investor realizes diversification reduces volatility but they also suspect diversification hurts returns (This belief is held by many investment advisors as well). The reality is diversification actually improve returns, not diminish them. Intuitively it doesn't make sense. Two years ago, convincing someone to build a ladder of U.S. Treasury Strips yielding 6% was almost impossible. Why would you want to build a ladder of U.S. Treasury Strips paying 6% when the market is earning 30+%? Sometimes we have to wait awhile to see the answer. In this case it didn't take long. Long-bonds paying 6% are now worth their weight in gold and the market with its cataclysmic drop helps us focus on the power of diversification. Not just for reducing risk, but for increasing returns. | ||||||||
| Functional Asset AllocationTM is simple but also hard, far more difficult then feeding your investment portfolio into a computer in order to "optimize" it. It requires an honest assessment of your current situation. It requires the discipline to ignore the "talking heads" on CNN and the "advice" brandied about by well meaning, but misguided friends, family and traditional advisors. Very often you must do things that, at least intuitively, don't make sense. Examples are, as mentioned above, buying bonds at 6% when the market was earning 30%. More recently electing to leverage (mortgage) an appropriate amount at 7% when the market is doing terribly and money markets are paying 2%. It doesn't make sense now, but it will later. It is worth the effort. When your portfolio is in PEAK condition money takes its rightful place allowing you to take yours.
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