Once you have blueprints and a foundation, what do you do? The next issue builders face is choosing materials—balancing cost and quality. And the next choice for structuring a portfolio is asset allocation.
Asset allocation balances risk and return. Different investment vehicles represent different forms of ownership, stand in different places in the capital structure, and so bear different levels of risk. In general, the more junior the claim your asset has on the cash flow of an entity, the more the risk that you don’t get paid, but the more upside you have if things work out, or if the business grows.
For example, bonds represent a senior claim on operating cash flow. For a business not to pay its bonds, it has to go through bankruptcy—a laborious and disruptive process, in which managers often lose their jobs. So people usually avoid this, and bonds usually get paid. Stocks, on the other hand, represent the most junior claim, and dividends get cut all the time. Shareholders can face losses for all sorts of reasons. But they also benefit the most if the business grows.
Other assets represent different sorts of claims. Short-term treasury bonds are the least risky asset out there. It’s almost inconceivable that a government won’t pay its debts in its own currency. After all, it can always print more! This could lead to inflation, but short-term bonds can be reinvested at the higher rates, so they’re less risky than long-term bonds, which bear inflation risk. Government bonds from states and municipalities—that don’t issue their own currency, but that do collect taxes—are a little more risky, but if the economy is growing and the local government is credible, they’re safer than almost everything else.
And then there are other sorts of securities—real estate trusts and master-limited partnerships. These instruments use various legal structures to reduce taxes. They’re not appropriate for all investors, though, so you need to do your homework!
Asset allocation is a critical step—but it flows from having a plan and policy specific to your needs. It balances the risk/return trade-off, and helps keep your portfolio on-track.
Douglas R. Tengdin, CFA
Chief Investment Officer