Asset Allocation is an investment planning tool, not an investment strategy --- few investment professionals understand the distinction. Fewer still have discovered the power of: "The Working Capital Model" (see chart) The problem that most investors have is that they use the wrong number to determine their Asset Allocation in the first place. Neither market value nor the calendar year should be relevant issues.
The only reason for a person to assume the risks associated with investing is the possibility of achieving a higher rate of return than is attainable in (the very few) risk free savings depositories for their capital (money). Investing is a get rich slowly process, conducted in an uncertain environment --- one that must be understood and managed in a way that minimizes the risks involved.
The Working Capital Model accomplishes this by eliminating the need for impersonal comparisons with arbitrary and unrelated numbers and time periods. It works best with portfolios that are diversified among individual securities that are at the same time of high quality and income producing.
The key to successful investment management is Asset Allocation, the process of dividing the available investment dollars into two, and only two, buckets: equity investments and income producing investments. All investment grade securities fit within one of these two classifications, based solely upon the primary purpose for their ownership. There are several key issues involved in successful Asset Allocation:
- Understanding the purpose of each security owned,
- Being true to the asset allocation formula,
- Knowing the cost basis of the securities in the portfolio,
- Worshiping Cash Flow, and understanding the "Smart Cash" concept. Smart Cash is that which arises from earned income of any kind, including Capital Gains.
Most humans enter the investment process greed first, thus transforming a relatively simple wealth enhancing exercise into a mass of confusing products and philosophies, destined to expand the pocket books only of the creative souls that produce them.
- Very simply, the purpose of any equity investment is the eventual production of a realized capital gain, or profit. This profit need not be huge, but it should be targeted in advance as a guideline and it certainly should be above the guaranteed return in a bank account. The profit must be realized as soon as it is available, so it is tax-helpful if equity Investments are housed in tax deferred quarters.
The Working Capital Model works best with equity investments that pay dividends, but this is more of a quality assurance element than a cash flow consideration. The primary purpose of equities is profit production, ASAP. Thou shalt not fall in love with any Equity holding --- ever.
Income securities should be the easiest to understand and to deal with --- they aren't. They are primarily income producers, and can be held for extensive periods of time doing absolutely nothing but producing cash flow. That is job one.
Most fixed income securities represent a contractual obligation between a corporation and investors: interest, dividends on a preferred stock, returns of principal, royalties, rent, etc, will be paid at periodic intervals. Investors become creditors of the issuing entity.
Obviously it pays to lend money only to corporations, municipalities, and others that have solid finances themselves.
Typically, longer loan commitments produce higher rates of return than shorter ones, and AAA insured obligations produce lower yields than those of a lesser quality. Investment Grade falls somewhere in between, and this is where The Working Capital Model keeps investors focused.
All income securities are Interest Rate Expectation Sensitive and will rise or fall in price depending on day-to-day perceptions about the direction of interest rates. This is expected and totally irrelevant. In fact, if an investor purchases the securities in the income portion of the portfolio properly, he or she will be able to add to holdings when they move higher in yield, AND to sell the securities profitably when they move higher in price.
Wall Street financial institutions and financial professionals almost never instruct investors to ignore the market value gyrations of income securities, but the facts remain:
- The primary purpose of these securities is income generation and investors should never accept or consider a lower rate of return in an effort to reduce volatility.
- Investors should never avoid adding to the fixed income asset allocation bucket for fear (or in anticipation of) higher interest rates.
- The Working Capital Model recognizes this, and works well with sound financial advice as it deflects the temptation either to transact or to sit back for the wrong reasons.
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