Sunday, February 18, 2007

Asset allocation and cash

As I gradually recover from my financial difficulties and bankruptcy of 2005, I am slowly accumulating cash and stock and in the not too distant future will have enough net worth that I will seriously need to have a formal asset allocation model. Other than my rainy day fund which is by definition 100% cash or near cash, I simply don't yet have a large enough pool of assets for it to be worth a formal asset allocation model and re-allocation process.

You could argue that with even $1,000 you should be at least considering the asset allocation issues, if only in anticipation of the future so that you will smoothly transition into the formal process when you do finally have enough, and I may in fact do so, but the sense of urgency simply isn't here right now.

The traditional asset allocation model has only three components: cash, bonds, and stock.

As you become more sophisticated (i.e., richer) you can add real estate and commodities.

As you become even more sophisticated (i.e., even richer), hedge funds, angel and venture capital, and all manner of "alternative investments" come into play. One difficulty is that some of these are so vague in terms of their precise risk profiles, that it can become near impossible to compare relative risks the way it is done with cash, bonds, and stocks.

Even with stocks and bonds, there are many sub-categories of assets that each has a dramatically different risk profile and different "days in the sun". We have growth and value stocks, small caps, mid caps, large caps, cyclicals, counter-cyclicals, staples, utilities, etc. We have junk or high-yield bonds, distressed debt, different grades.

Personally, I don't like bonds, simply because they are not as liquid, not as fairly priced, and how they trade is simply beyond the comprehension of typical investors. Even with a "good" bond fund, you are acting on "faith" in the reputation of the manager and it is virtually impossible to really know what is in there and its true risk profile.

Treasuries are a different matter, and in fact many of them can be treated more like cash than a corporate bond. Even so, you have spreads, inflation expectations, economic growth expectations, etc. to muddy the waters.

My immediate issue is that I need to decide whether that big pile of cash in my rainy day contingency fund counts as cash in my eventual asset allocation model, or doesn't since I won't reduce that cash if the model shifts out of cash. My inclination is that it is outside of the model. Which means that my current, default "model" is essentially 100% stock, albeit a small absolute amount, which is far from ideal. That's my starting point in my thinking. But, I need to consider a few alternative models before coming up with my initial model goal.

-- Jack Krupansky

1 Comments:

At 3:45 AM EST , Anonymous Anonymous said...

I read your blog with a lot of interest.
Probalby a book from David F.

Swenson can help you allocate your assets in the long term. His conclusion is that timing and asset selection is less important than assect allocation.

If you are more on the trading trip then try Van Tharp. His theory is that you need to reduce risk by risk-return multiples and that the only parameter you can control is when you exit the market.

I should have read Van Tharp in 2000 and I should have switched to Swenson over the last 3 years .... it all depends on the market environment. If it is volatile then go with Van Tharp - if you are long term definitely not.

Regards from Munich, Germany

 

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