"Moderation, which consists in an indifference in little things, and in a prudent and well-proportioned zeal about things of importance, can proceed from nothing but true knowledge, which has its foundation in self-acquaintance." Plato (428-348 BC)
Balance and moderation are central themes to both ancient eastern philosophy and western philosophy. This quote from Plato lays the philosophical foundation of "self acquaintance" or having "true knowledge" of our own strengths and weaknesses. It also speaks directly to my asset allocation lesson today. With this portfolio, we take one step away from the passive "Rote Model" in my previous blog post to a model that requires a "prudent and well-proportioned zeal," as Plato words it, and a step toward active management of your investment portfolio.
For purposes of my Balanced Model, I will assume that the investor has a moderate tolerance for risk; has a long-term (more than ten-year) time horizon; chooses to manage their own portfolio; has average to above-average knowledge of investments and financial markets (but not an "expert"); and is seeking to maximize returns while minimizing risk. Since Plato's "self acquaintance," similar to Socrates' "know thyself," philosophy is the thread that runs throughout prudent investing, my lesson will begin with how the average investor, as a flawed human being, views the risks associated with investing. Two prominent and related theories derive investment strategies from how we perceive risk:
Modern Portfolio Theory (MPT) and Post-Modern Portfolio Theory (PMPT) are highly regarded investment theories that have gone quite far in constructing a prudent, well-balanced portfolio with significant consideration of the average individual's perception of investment risk based upon statistical models. In short, MPT is a Nobel Prize-winning theory of global equilibrium, centered upon its "mean-variance optimization (MVO)." PMPT essentially debunks MPT, not because the theory is no good but, because MPT equates standard deviation to risk, which is flawed when placed in a real world scenario with the average investor. PMPT presents a new method of asset allocation that optimizes a portfolio based on returns versus downside risk (downside risk optimization, or DRO).
Since this post is not intended to offer specifics on investment theory, I'll simply say that my Balanced Model portfolio is closely aligned with PMPT and will offer a rough translation of this complex statistical jargon:
- Most people are more risk averse than they are risk tolerant, meaning a loss provokes stronger emotions (on the negative side) than a gain (on the positive side). We like to make money, but "not losing" it is more important!
- Above-average and frequent gains (accompanied by small and infrequent losses) is preferred over tremendous gains occurring infrequently (accompanied by periods of above-average loss).
- Investors see risk in three ways: 1) Risk of loss, 2) Risk of under-performance, and 3) Risk of failing to meet one's goals.
To summarize, a successful Balanced Model will achieve frequent gains that are average to above average while keeping losses relatively low and infrequent. To achieve this balance, you may have guessed that the time-tested strategies of dollar-cost averaging and diversification are essential. Dollar-cost averaging can be achieved by consistently contributing money to your account at regular intervals, such as monthly. This will remove any timing issues while buying more shares when stock prices are falling and buying less shares when stock prices are rising. As for diversification, a good Balanced Model will consist of a "core" fund and four or five supporting funds:
- The core fund should be a low-cost, large cap stock index fund, such as Fidelity Spartan 500 Index or Vanguard 500 Index and should comprise at least 30% of the entire portfolio.
- Allocate 15% to an actively-managed Foreign Stock fund;
- 10% to an actively-managed Small-Cap Stock fund;
- 10% to a "defensive" stock fund (currently, Health Care is a good defensive area); and
- 35% to a "Multi-Sector" Bond fund, which will cover a broad range of bond types.
This model will provide an asset allocation of 65 percent stocks and 35 percent bonds. An investor could reasonably expect an annualized average rate of return of approximately 8 percent for this Balanced Model.
To say the least, this blog post is somewhat simplified but may serve as a prudent foundation for the average investor's long-term investment strategy. Since active management on the part of the investor is required for the Balanced Model, it is important to also remember re-balancing, which requires the investor to buy and/or sell shares of the appropriate funds to return the portfolio allocations to the original target percentages. For the average investor, I suggest doing this once per year.
There is much more to learn. I did not even touch on investment selection or investment monitoring strategies. For this reason, I stress that you be highly aware of your strengths and weaknesses and keep an open mind to hiring a financial planner who is registered as an investment adviser that can analyze your entire financial picture and manage your investments while allowing you the added time to focus on your true passions in life...
For those investors hungry for more knowledge and for those with the desire and capacity to take even more of an active role in their investment strategies, stay tuned for my forthcoming "Socratic Model" post...
TFPAuthor, Kent Thune, is the President and Owner of Atlantic Capital Investments, LLC (ACI), a fee-only, registered investment adviser based in Mount Pleasant, SC, near Charleston. ACI specializes in retirement, investments, and comprehensive financial planning.
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Posted by: RX-order | November 19, 2010 at 11:18 PM