Your Little Book of Asset Allocation: Everything You Need For Worry-Free Investment

By Johanna Wychcote

Here's the problem: you want to invest for the future, but professional advisors cost too much and you don't have the time or expertise to manage a stock portfolio. 

 

It needn't be a problem. In fact 80 percent of investors' returns come from asset allocation - that is, what kind of assets you buy - rather than from active stock picking. This book takes you through the process of structuring an investment portfolio that's right for your individual situation while actively managing the risks involved. 

 

By the time you've read the book, you'll have an idea about the theory that underpins asset allocation strategies, but more importantly you'll be able to build your own portfolio using low-cost investment methods. And you won't need advanced math to get there.

• Language: English
• Publisher: Practical Press
• Release date: May 9, 2022
• ISBN: 9798201644178

Johanna Wychcote

Johanna spent twenty years working in finance before quitting to go it along before she burned out. She's built her own investment portfolio and a small real estate business, and now writes ebooks on investment topics as well as spending her spare time painting watercolour landscapes.

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Johanna Wychcote

Your Little Book of Asset Allocation: Everything You Need For Worry-Free Investment

It's tough to make predictions, especially about the future.

(Attributed to Yogi Berra)

Introduction: Why I've written this book

When I first started work on the Stock Exchange, I wasn't particularly well off. My rent took a huge bite out of my pretty small salary, and I had relatively little money to save after I'd paid my living expenses. But I had a bit, and so I invested it - in one stock, a small but fast-growing advertising agency.

Fortunately, I did quite well out of that investment. But it still gives me the shivers to think that almost all my worldly wealth was sitting in a single stock. If things had gone wrong, I would have had nothing to show for two or three years of investing.

Everyone thought I was clever to have made good money out of that stock, except for one old and wise trader I worked with.

That's the only stock you've ever dealt, he said. You ought to tuck away at least ten. Otherwise, if one goes bang, you're up the Swanee, aren't you?

I mentioned that to the Head of Research, who told me this concept was called diversification. Then, later, talking to fund managers, I found out about asset allocation not just as a means of diversifying, but also as a way to manage your portfolio strategically. At this point, I stopped being a rookie, and started actually understanding what I was doing.

'Asset allocation' isn't the most user-friendly phrase but it's actually not a difficult concept. Instead of trying to pick the best stock in the world, and then the next one, you look at the entire universe of different assets you can invest in, and decide how you should lay your money out. So it's like shopping for the ingredients for a cake, rather than trying to find a single nugget of gold. If you get all the ingredients in the right proportions your cake is going to rise properly in the oven and come out tasting great - and bigger than it went in. If not, you have a potential disaster on your hands.

Or you could look at it another way. If you want to build a house, some people will go scouting for materials - the best wood, or the cheapest bricks, whatever. On the other hand the asset allocation view says first, let's draw the plan. Then we can find out what materials we need.

You may have heard about fund managers who take a 'top down' or 'bottom up' view. Well, 'top down' is asset allocation style. You look at the world, and you say: Where should I put my money, and how much of it should I put there? (A big bonus is that if you take the 'bottom up' or stock picking approach, you end up spending a lot of time searching for the right investments. Asset allocation can be done using funds and particularly exchange traded funds (ETFs).

Research has shown that asset allocation is responsible for more than 80% of mutual fund performance. In fact, in 2000, a study by Ibbotson and Kaplan found that it was more than 90% in the long term. So if you adopt a 'bottom up' view and try to cherry-pick investments, even if you're right, you've spent all your time worrying about 10% of the returns, when correct asset allocation could have given you the other 90%.

Asset allocation is about looking at types of risk, and deciding how much of what type of risk to take. So there is no one right answer; your ideal allocation will reflect your own preferences, your age, your resources, and your financial situation. It's something that you need to do for yourself, because no one else knows you as well as you do.

It also doesn't need any huge skill in math. You need to understand the theory about how stuff like standard deviations and betas work, but you don't need to understand how to calculate them - we have computers to do that these days, and everything you need, you can find online. I've also tried to space out the math- and theory-heavy chapters between less intense chapters, to give you a break.

In fact, if you don't like doing too much math, asset allocation is undoubtedly the best way for you to invest, because you can use this approach to cut out a lot of the work you don't want to do;

company analysis

stock-picking

predicting interest rates

calculating valuations.

You can leave all that kind of stuff out, and just spend a couple of days a year on your investments, and you will do just fine. If you want to be both a lazy investor and a successful one, asset allocation is what you need.

On the other hand, if you're really into the math and statistical treatments behind an asset allocation approach, this book will give you an understanding of the basic terrain but you'll want to go further into those aspects. William Bernstein's The Intelligent Asset Allocator is a great book if you really want to get behind the science of asset allocation, but hard going if you are not a numbers-focused person.

This little book is going to give you everything you need to know about diversification and asset allocation. I've written it in easy to understand language, though there will be a bit of jargon from time to time - but don't worry, I'll explain the jargon when we see it. It's easy to read, and it should help you think about your finances and how to invest in a way that will let you sleep at night.

Different classes of asset

Let's talk about asset classes. The three traditional asset classes for financial investment are equities, bonds, and cash.

Equities are shares in companies - where you buy, basically, a one-millionth of Amazon, or a teensy-tiny-percentage of Tesla or Chipotle. You own a share in the business, and you're rewarded by capital growth, and possibly by a dividend, which is paid entirely at the discretion of management. Shares are traded on the stock exchange, and their prices go up and down in accordance with demand and supply - that is, depending on investors' expectations of whether the shares will perform well, or not.

Bonds are, in essence, IOU's. You lend money to a company, and it will repay it on a certain date. It will pay you interest for the lifetime of the bond, which might come to you every year as a 'coupon' or which might come to you in one big payment at the end. Or, you might buy the bond for 80% of its real value, and be rewarded by being given back 100% of the value when it's paid off. In any case, you get interest, like a bank account. But unlike a bank account, bonds can be traded, so the price can go up and down, again in accordance with demand and supply from investors.

Cash is, well, cash. It includes near-cash investments such as short term government bonds (in the US), money market instruments, cash funds, and CDs.

Funds that invest purely in these assets are also regarded as traditional assets. If you invest in an equity fund, you have an equity asset; if you invest in a bond fund, it's regarded as a bond asset, because we look at the underlying asset, not the way you hold it. You might also invest in a multi-asset fund that invests across these asset classes.

But there are other asset classes that are generally referred to as alternative assets. Some are exotics, while others are quite traditional investments, but they all tend not to have a strong correlation to the financial markets. So these asset classes can give you more diversification, which we've already talked about - they can help you to spread your risks.

Real estate is land and buildings, and can be held directly, through a fund, through a partnership, or by buying shares in a real estate company.

Private equity and venture capital are investments in private companies. Generally, you'll need to be pretty wealthy (or work in a start-up) to be involved, but you can also access some private equity opportunities through funds or crowdfunding.

Commodities are raw materials, either extracted from the earth (gold, oil, gas, iron) or agricultural products (pork bellies, wheat, corn).

Cryptocurrencies technically are cash, but because of their highly volatile price, should really be treated as an alternative investment.

Crowdfunding, again, isn't really an asset class, because you will be either investing in a business (equity) or lending to it (bond), but because of the way crowdfunding operates, it's probably best to treat it as a separate asset class.

Collectibles such as wine, vintage cars, and art form another asset class. I'm not going to talk about these, as unless you are an expert, these are assets that are difficult to value and also difficult to sell. It's also very difficult to track whether you are making money or not.

Most people think of their lives in two baskets. There's the stuff you own and use, then there's the stuff you invest in. Usually, own and use is a