When it comes down to investing for the long term, asset allocation is the most important concept to understand. I remember my seminar in finance course during my final year in business school to this day for that very point. The professor said unemotionally, it’s not weather you invest in Microsoft or IBM that matters in the long run, it is how you position yourself in equities, bonds and real assets that makes the difference. Huh, interesting. So what he was saying was that you could be the best stock picker in the country, or your financial advisor could be, but that would be inconsequential in the long run if equities were not blended properly in your portfolio. So how do you begin to diversify between the following?
Balancing risk versus returns is the cornerstone of many investment approaches. One approach is to manage your investment portfolio’s performance by focusing on asset classes and investments with the potential to outperform relative to risk. While risk increases and decreases over time based on certain factors, it never totally disappears. This is why diversification is an important consideration when seeking to mitigate the risks that uncertainty creates. Depending on your investment goals and risk tolerance, you will typically diversify your portfolio with a mix of equities, bonds and real assets.
Portfolio analysis of this kind usually begins with a macro oriented top-down approach, which starts by determining the proper asset allocation by assessing the greater economic picture. Uncertainty and volatility create risk, but also opportunity. Indicators of such are things like interest rates, corporate earnings, trade and the like. One could begin to break this down further by looking at the following categories:
- Long-term trends – such as demographics and productivity
- Cyclical trends – including a current reading of the business and credit cycles
- Short-term trends – like monetary policy and projected growth in corporate profits
- Private market and illiquid strategies – possibly providing additional portfolio diversification opportunities
- Impact investing performance – including social, environmental and governance activities
Now enter the growing macro concern of the present- inflation. According to legendary investor Paul Tudor Jones, among others, “Inflation is the number one issue facing investors today.” The alarm bells are sounding because the largest and wealthiest demographic of society, the baby boomers, are worried about their retirement. Jeremy Siegel, finance professor at the Wharton School at the University of Pennsylvania, who’s known for his positive market forecasts, said he anticipates inflation will be a much bigger problem than the Federal Reserve believes. According to a survey by Personal Capital and Kiplinger’s Personal Finance, 77% cited declining purchasing power as a major worry, followed by health care (74%) and the financial strength of Social Security (71%).
Albeit transitory or of a longer duration, inflation can have a dramatic effect on your wealth management approach. So what is one to do? To begin, we should break down the demographics into three broad categories; your younger years, your nearing retirement years, and year actual post-work retirement years. The younger years are relatively straight forward, but can be a bit confusing when it comes to adjusting for inflation. First off, at a younger age you have time on your side to ride out the ups and downs in the broader equities, fixed income and real asset markets. However, a popular misconception is that during inflationary uncertainty one should allocate away from risk and become heavier in cash. This is a mistake. According to James Burton, chief marketing officer at Personal Capital, “It is tempting to keep a lot of money in cash because it feels secure, but the truth is it is not secure. It is likely to be eroded by inflation very significantly over time.” For example, consumer prices jumped 5.4% in September year-over-year, yet bank interest rates on savings accounts are well below 1%, thus eroding the value of every dollar you have in the bank. While every investor is unique, the rule of thumb is that if you are under age 50, the bulk of your retirement portfolio should be in stocks, as the average return over the last 20 years has been 9.55%, which should be enough to hedge against the coming and going of inflation.
As you are nearing retirement, roughly in your post 50 years, you will want to start allocating your assets away from riskier equities into the fixed income category. While bonds can certainly be eroded by inflation, there are Treasury inflation adjusted bonds or TIPS, that can be used, as the principle portion of the security is adjusted for inflation. During this midlife period, you should also consider asset classes that are less correlated to the equities markets. Areas like commodities, including the metals and energies can be used to balance an individual portfolio. In addition, as you approach retirement, you will want to consider Social Security and the amount that it will be in your retirement income. Remember, Social Security is an inflation-adjusted benefit, and as beneficiaries will see in 2022, the cost of living adjustment will be a 5.9% increase, the largest in some 40 years, making up for decades of little to no increases for beneficiaries in the previous low inflationary environments.
Once you are no longer working, you will want to be invested in income generating assets like TIPS and other bonds to supplement whatever pensions or Social Security you might be drawing. It is important to maintain a small portion in equites still, as longevity has increased in recent decades, allowing you to continue to benefit from potential market gains, albeit as a smaller portfolio percentage, but none the less, to still attempt to outperform inflation.