Asset allocation is how an investor divides their assets among various asset classes available in the financial markets. Most financial professionals agree that asset allocation is one of the most important decisions that investors make. In other words, the selection of individual securities is secondary to the way an investor allocates investments in different asset classes such as stocks, bonds, and cash and equivalents.
At Henssler Financial, we employ a strategic asset allocation that involves periodically rebalancing a portfolio in order to maintain a long-term goal for asset allocation. In contrast, there is a tactical asset allocation in which an investor shifts the allocation to take advantage of perceived value in the marketplace with short-term gains.
The economic environment ultimately drives the allocation decision as asset classes perform differently in each stage of an economic cycle. Let’s first look at the different stages of an economic cycle:
Initial Recovery from Recession
An initial recovery generally lasts a few months. It is often characterized by low or falling interest rates, falling inflation and rising stock prices. During this time, bond yields may have bottomed out and business confidence is rising. Stock prices also begin to rise.
Early Expansion
An early expansion can last from one to several years. It is a time of increasing growth with low inflation. Short-term interest rates begin to rise, as do stock prices. Businesses tend to have increasing inventories and confidence during an early expansion. Bond yields will be flat or beginning to rise.
Late Expansion
Once confidence and employment are high and we see inflation increase, the economy is considered in a late expansion period. Short-term interest rates, bond yields and stock prices generally are all rising. A country’s central bank will often limit the growth of the money supply. However, during a late expansion, market risk increases as investor nervousness increases.
Slowdown
An economic slowdown may last a few months to a year or longer. It is marked by declining confidence, falling inventories and stock prices, but inflation is still rising. Short-term interest rates are generally at their peak, and bond yields have peaked and may begin falling.
Recession
A recession generally lasts six months to a year and is marked by negative growth of gross domestic product and high unemployment. The marketplace will see a large decline in inventories, declining confidence and profits, and inflation generally ceases to rise. Short-term interest rates fall, as do bond yields. However, bond prices usually increase.
Determining the stage of an economic cycle is mostly done in hindsight, since each stage is relative to the next. Thus, it is not easy to predict the best performing asset class from year to year. Having a mixture of asset classes in your portfolio aims to reduce the overall financial risk in terms of the variability of the returns. Let’s look at different asset classes, and how they have historically acted during different economic environments:
Cash
Cash is the most basic, liquid asset and good to hold in times when all other financial assets are declining. It is bad to hold during inflationary times, as it can be exchanged for less goods and services.
Commodities
Commodities are generic, unprocessed goods that can be processed and resold. Commodities include oil products; food products like wheat and corn, and metals, such as gold and silver. They are considered good holdings for inflationary times, because they are the raw materials for manufacturing. Commodities seldom outperform other financial assets over the long term because technology tends to reduce the amount used in finished goods. It is difficult to determine the underlying value of commodities as they have no earnings or fundamental values like companies. Commodity prices are determined by supply and demand.
Real Estate
Real Estate is land and anything permanently fixed to it, such as, buildings, sheds and other items attached to the structure. It is considered a long-term holding with good cash flow, but very illiquid and price does not always increase over time.
Bonds
Bonds are legal promissory notes, and vary widely in maturity, security, and type of issuer. They are generally considered safer than equities because of the legal structure. Bond prices appreciate in times of declining interest rates and are regarded as good holdings in times of “flight to safety” or during an economic slowdown or recession. All bonds tend to fall in price when interest rates increase. The bond asset class includes:
U.S. Treasuries
U.S. Treasuries are a debt security backed by the full faith and credit of the U.S. government, and considered safest of financial investments with a low yield relative to other bonds. They are often considered “risk-free” as it is all but unthinkable for the United States to default on their debt
Certificates of Deposit (CDs)
CDs are savings certificates that entitle the bearer to receive interest. CDs are generally issued by commercial banks and are safe when insured by the FDIC.
Municipal Bonds
Municipal bonds can be general obligation or revenue bonds, which can include sewer, electric utility, hospital, and university or development bonds. The safest are general obligations, although some have defaulted.
Sovereign Debts
Sovereign debt is issued by foreign governments and generally safe in developed nations; although, Russia defaulted in 1998 and caused an international financial crisis.
Corporate Bonds
Corporate bonds are backed by the issuing company’s ability to earn from future operations. Corporate bonds are considered riskier than government bonds.
Inflation Protected Bonds
Inflation protected bonds guarantee a real rate of return, which is the nominal return, less the inflation rate. Their principal value is generally adjusted to counteract rising price levels.
Bond Funds
Bond mutual funds are not like holding fixed yield bonds. Bond funds have no guaranteed maturity value, interest payment or maturity date. They are more like floating rate bonds with prices that adjusting according to interest rates, average quality, average maturity and business sector exposures.
Stocks
Stocks allow the holder to participate in a company’s earnings stream to some degree. They generally perform best during an early recovery into the peak of the economic cycle. Some stocks pay dividends that can give the stock price a “floor,” thus making them less volatile in bad fiscal times; however, dividends can be cut. Stock holders participate in company growth via price appreciation even when the company does not pay a dividend. Negative growth, missed earnings, short interest and fraud are part of the risks associated with stocks.
Alternative Investments
Alternative investments include hedge funds, private equity, structured products, managed futures, currencies and futures and options. Most alternative investment assets are held by institutional investors or accredited, high-net-worth individuals because of their complex nature, limited regulations and relative lack of liquidity.
At Henssler Financial, we follow our Ten Year Rule that states any money needed within the next 10 years should be invested in fixed-income investments, and any money not needed within the next 10 years should be invested in common stocks or mutual funds that invest in common stocks.
Currently, we have growth in gross domestic product and industrial production. Inflation is low compared to historical levels. However with the unemployment rate higher than we are accustomed to, we consider the economy to be in an early- to mid-expansion period. This further reinforces our belief that the growth portion of an investor’s portfolio should be in stocks. While companies are still only slowly hiring, they have been more profitable as evidenced by a 31% rise in earnings during the fourth quarter of 2010.
Disclosures
This article is meant to provide valuable background information on particular investments, NOT a recommendation to buy. The investments referenced within this article may currently be traded by Henssler Financial. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. Henssler is not licensed to offer or sell insurance products, and this overview is not to be construed as an offer to purchase any insurance products.
