Of the major asset classes readily available, guess which one enjoyed the highest returns last year. If you guessed emerging markets, you’d be right. Emerging markets as a group jumped 37 percent during 2007 as measured by the Vanguard Emerging Markets Index. You can probably easily guess which did the worst — real estate, Real Estate Investment Trusts to be precise. REITs as a group fell in value by 16.7 percent. Quite a spread from first to worst.
Based on that record, it should have been a no-brainer to guess where to load the boat for 2008, right? Not so fast. As a matter of fact, last year’s dog, REITs, are actually doing quite fine this year, rising by nearly 4 percent. And how do you think last year’s star is doing? Not so well actually, as the Emerging Market index is down by 19 percent since the beginning of the year (China’s stock market, in particular, is off a whopping 55 percent).
Up one year, down the next. If only there were some foolproof way to know in advance which group would be the hero and which would be the bum. The money that could be made.
Wake up; it can’t be done! If it could it would, and whoever cracked that code would be the richest person in the universe.
Fortunately, knowing that future is not a requirement for long-term investment success. In fact, trying to ponder and guess that future can, in some cases, actually be self-defeating — holding the risk of steering you away from the very areas you should be considering at the most optimum time (and that would be, of course, right after a period when they have done dreadfully). So what’s a poor boy to do?
The answer is simple, tried and true. It’s also poorly-practiced because it takes discipline to execute properly. And on occasion, it can also seem downright boring. I’m speaking of asset allocation. Proper asset allocation. A thoughtful apportionment between stocks (domestic, international, large-cap, small-cap), bonds, real estate, commodities and cash. If you want to achieve a long-term measure of success in the financial markets, forget overworking specific stock-picking techniques, forget picking the hottest sector fund, forget trying to pinpoint the bottom (or top) of a market. These exercises, while interesting and tangentially related to success, pale when compared to the real workhorse of long-term results — strategic asset allocation. Get your allocation right, and you’re on your way.
Let me tell you a story. Back in the beginning of 2000, a certain young CEO of a newly-public tech company found himself to be worth somewhere north of $2 billion dollars following his company’s IPO. His CFO, a middle-aged accountant, also hit the jackpot, as his stake in the IPO was valued at a not-too-shabby $40 million dollars.
Understandably, both individuals were heavily pitched regarding the investment future of those fortunes. After hearing a number of financial presentations made, many of which implored these two men to adopt a broad and diversified asset allocation plan for their new-found wealth, the two men arrived at very different conclusions regarding what course of action they would take. The CEO, modest as he was, simply believed that his success would continue. He commented that he was quite sure that his $2 billion fortune would at some point be worth $10 billion. No need to diversify. The CFO on the other hand realized how unlikely it was that someone with his somewhat modest accounting background should stumble into such a windfall. He decided that, above all, he wanted to hang onto his newfound wealth. He listened carefully to the advice given to him and fully diversified into a mix of U.S. stocks, non-U.S. stocks, real estate, bonds, commodities, inflation-protected securities and cash.
You can probably guess what happened. After the tech-boom turned into the tech-bust, the CEO’s net worth crashed. How foolish, predictable and preventable. But, the asset-allocating accountant/CFO obviously had quite a different outcome. In fact, because of the common sense decisions to properly allocate, he is today worth many times more than his former boss.
Did that outcome require forecasting skills or superior security selection? Not at all. All it required was the sense to realize that proper asset allocation is key to wealth is preservation, maintenance and growth; the design of such a plan; and the discipline to implement it. You see, asset allocation really is the driving force behind investment success. It has been practiced by endowments, foundations, public and private pension funds and very wealthy families for generations. It builds, protects and creates additional wealth. And it should be the cornerstone of any serious investment portfolio.
We’ll examine some of the considerations in developing a successful asset allocation plan next month.