Optimum Asset Allocation Model?

 If not an outright trick question, the title of this blog is misleading. The optimum asset allocation can only be determined in retrospect, for nobody can read the future. At least not accurately. When establishing an asset allocation model for an investor, one size does not fit all. Multiple variables come into play when establishing an investor's customized asset allocation parameters. Besides personal preference and financial goals, the next most important component would be somebody's level of risk tolerance. A person who can't psychologically deal with a stock market correction (down 10%) or a Bear Market (down 20%) should have minimal portfolio exposure to equities. Other important factors to take into consideration would be an investor's age, health, and level of current and expected interest rates.

Before looking at different allocation models, let's delineate the major asset classes. These asset classes would be as follows: 1.) Cash and Cash Equivalents (includes Treasury bills); 2.) Equities (stocks); 3.) Fixed Income (bonds); 4.) Real Estate; 5.) Precious Metals (gold and silver); 6.) Commodities; 7.) Foreign Currencies; 8.) Cryptocurrencies; 9.) Collectibles. It goes without saying many of these categories could be further divided into sub-classes. For example, Fixed Income could be broken down into U.S. Treasuries, corporate bonds, and municipal bonds. Real Estate could be further divided into residential, commercial, and agricultural real estate. For our purposes, we'll stick with the general classes in order to avoid getting stuck in the mire of excessive details.

Historically, 60% equities and 40% bonds has been the most common allocation recommended by financial advisors. This has been considered a balanced portfolio and has been the standard for decades. Quoting songwriter and crooner, Bob Dylan - "And you better start swimmin', Or you'll sink like a stone, For the times they are a-changin'." There has been an evolution away from 60/40 and toward other investment allocation options. The primary reasons away from 60/40 would be high equity valuations, Federal Reserve Bank monetary policies, increased risks in bond funds, and low prices in the commodities' markets. Many experts are now saying that a well-diversified portfolio must include more asset classes than just stocks and bonds. Besides those asset classes itemized in the previous paragraph - private equity, venture capital, and private credit are now often incorporated in the modern investment portfolio.

There once was an old rule of thumb that utilized the investor's age to determine the stock/bond allocation in a portfolio. For a thirty-year-old, the recommendation was to hold 30% in bonds and 70% in equities. For a fifty-year-old, the recommendation was to hold 50% in both stocks and bonds. Thus, for a seventy-year-old, the recommended allocation was 70% in bonds and 30% in equities. In our topsy-turvy world, older investors these days often turn this approach on its head and flip-flop to 70% equities and 30% bonds. The percentage Baby Boomers are allocating to stocks is at an all-time high. These folks are ill-prepared to weather a 30%-50% down market.

I've always been partial to the 30/30/30/10 allocation model allocated as follows: 1.) 30% - stocks; 2.) 30% - bonds; 3.) 30% - real estate; 4.) 10% cash. The double-digit percentage in cash would be applicable when short-term interest rates are depressed as they were during the Covid-19 pandemic. Otherwise, I would take cash to 5% and increase equities to 35%. In an environment where the continued debasement of our currency is a distinct possibility, I would be comfortable with the following allocation: 1.) Equities - 40%; 2.) Fixed Income - 20%; 3.) Real Estate - 25%; 4.) Gold and Silver - 8%; 5.) Bitcoin - 2%; 6.) Cash - 5%. Equities, real estate, and precious metals total 75% in this scenario and offer some protection against inflation. If major inflation and loss of purchasing power are a strong possibility, the 12/20/80 asset allocation rule may appeal to some. In this scenario, an individual holds 12 month's worth of expenses in safe, liquid funds. Then, the remainder of his assets are divided between equities (80%) and gold (20%).

For those investors with a contrarian bent and a morbid fascination of market crashes, I suggest extending consideration to what I'll refer to as a "Black Swan Portfolio." In the context of finance, a black swan event is used to describe a rare, random event that nobody sees coming that poses a significant risk to the stock market and economy. Some historical examples would include 9/11, Great Financial Crisis (2008), and the Covid-19 pandemic (2020). The term is closely associated with the trader and author, Nassim Taleb, and founder of the hedge fund Universa, Mark Spitznagel. The "Black Swan Portfolio" is quite basic in its application and has been widely successful in the rare times it has been implemented. The first component of the strategy is to go long the S&P 500 Index for 97% of your investment portfolio. Using the SPDR S&P 500 ETF Trust (ticker symbol SPY) is an instrument that can be used. Next, with the remaining 3% of your portfolio, buy deep out-of-the-money put options on SPY (60-90 day expirations), and do this on a regular basis. By doing this you are effectively shorting the market, tail-risk hedging, and possibly realizing a windfall if a Black Swan event materializes. Be prepared  to suffer small losses for literally years before the money spent on the constant purchase of put options pays off. As mentioned, the Covid-19 pandemic was a Black Swan event and the market tanked in March 2020. The aforementioned Mark Spitznagel's hedge fund (Universa) made a return of 3,612% for that month alone, and over 4,000% for the year 2020. I have to assume Universa's investors were elated to benefit from a 40 bagger in 2020.