Market Capitalization Asset Allocation

Coca Cola Stock CertificateOne particularly popular strategy used by asset allocation investors is to divide their stock investments into different “piles” based on market capitalization.  (If you are a new investor, you may not know what market capitalization is.  Market cap, as it is often called, is the price it would take to buy 100% of all of the outstanding stock in a company at the current market price.  For instance, Coca-Cola currently trades at $57.68 per share.  There are approximately 2,317,267,684 shares of stock in existence.  To buy every share at the current market price would cost $133,660,000,000.  So, $133.66 billion in the market capitalization of Coca-Cola.)

Small Cap, Mid Cap, Large Cap, Micro Cap … What’s It Matter?

A century of research by esteemed firms such as Ibbotson & Associates shows that smaller capitalization stocks generate far higher returns over long periods of time.  Yet, due to their relatively smaller size, they are far less stable, often experiencing higher highs and lower lows than their larger counterparts.  That means that most investors don’t have the emotional strength to be exposed to that kind of volatility, even if it means they have a better chance, based on historical evidence, of growing wealthier.  So what do they do?  They balance the strength of blue chip large cap stocks, strong mid-cap, and high-growth small cap and micro cap stocks.

Although there are no hard and fast rules, most asset allocation experts tend to divide market capitalization asset classes as follows:

Asset Allocation Rebalancing

Asset Allocation Rebalancing StrategyOne of the cornerstones of asset allocation is the concept of rebalancing.  Done correctly, rebalancing forces you to buy certain investments when they are undervalued (cheap) and sell when they are overvalued (expensive).  In effect, it makes the owner of the portfolio a value investor without the need to analyze individual companies.  It can even be taken one step further with something known as tactical asset allocation.

How Rebalancing Supports Your Asset Allocation Strategy

Once you’ve chosen an asset allocation model portfolio, you will find that as time goes on, your asset class balance will naturally come undone.  If real estate falls as bond values rise, you would end up owning far more bonds than real estate, which is not part of your overall asset allocation strategy.  The experts created the rebalancing strategy as a solution designed to help you achieve your financial goals and objectives.  In effect, rebalancing forces you to buy low and sell high.  Here’s how it would work.

Imagine that you have a portfolio with a $100,000 market value.  You follow the Benjamin Graham asset allocation model and begin by putting 50% of your money, or $50,000, in stocks, with the remaining 50% put into bonds.  You select the Dow Jones Industrial Average iShares (Ticker Symbol IYY) and the Vanguard Intermediate Term Bond ETF (Ticker Symbol BIV).

International Asset Allocation 101

British Pound Sterling BanknotesMost growth asset allocation model portfolios call for exposure to the international asset class. In fact, in the article Factor In Your Income Sources When Seeking Diversification, I explained that one of the ways my own family reduced the risk involved with having such a big part of our net worth invested in private businesses involved in domestic manufacturing was to park almost all of our retirement assets and plans in international stocks, bonds, mutual funds and real estate.

What does that mean?  How are you, as a dedicated asset allocation investor, supposed to purchase foreign investments?

This introductory article was designed for investors that want to know some of the ways to add global diversification to their portfolio.  In today’s world of interconnected economies, it’s far easier than it was only ten years ago.  In fact, it’s you could add international stocks to your asset allocation portfolio within a few minutes of reading this article.

Global Asset Allocation
The Beginners Guide to Investing Abroad

When you invest internationally, it simply means that you are putting money to work in a country other than the one in which you reside and remain a citizen.  International investments are no better or worse, in most cases, than domestic opportunities but they provide a mechanism to diversify country risk.  Perhaps the best way to explain this concept would be to look at the United States.

The Talmud Asset Allocation Model Portfolio

Talmud Asset Allocation ModelAsset allocation is a cornerstone of modern portfolio theory, yet it’s as old as mankind itself.  In fact, the first known asset allocation model can be found in the Talmud.  Even more interestingly, those who followed the ancient investing prescription actually beat the market over the past decade.  Is the Talmud asset allocation model right for you and your portfolio?  Let’s take a look at the specifics.

The Talmud Model: Three Asset Classes, Divided Equally

The Talmud model of asset allocation calls for you to divide your money into three piles and then invest the money into each of the following asset classes equally:

Passive Income Asset Allocation Model Portfolio

Passive Income Portfolio Asset Allocation ModelAsset allocation models designed to generate passive income for investors remain among the most popular of all time because everyone wants to be able to live off their money.  Whether you are retired and need to augment your Social Security income, or you are wealthy and want to generate passive income without touching your principal, this asset allocation model may be a viable solution to your investing needs.

Asset Classes in a Passive Income Asset Allocation Model

The most popular asset classes for passive income asset allocation model portfolios often include:

Balanced Asset Allocation Model Portfolio

Balanced Asset Allocation Model PortfolioA balanced asset allocation model portfolio is one designed to generate a steady combination of growth, income, and capital preservation.  The intention is to create a combination of asset classes that results in lower overall volatility so the investor doesn’t need to worry about wild market fluctuations because the holdings in their account mitigate each other to some degree.

Sample Balanced Asset Allocation Model Portfolio

A typical balanced asset allocation model portfolio may look something like this:

Growth Asset Allocation Model Portfolio

For young investors in their 20s, 30s, and even 40s, with decades until retirement, steady jobs, and plenty of savings, an aggressive growth asset allocation model portfolio may be the best choice.

The caveat: If the investor cannot handle volatility, watching their assets drop 50% on paper one year or skyrocket the next, they should go for a balanced asset allocation model portfolio instead because they will be emotionally happier, even if it means they won’t be as rich as they could have been.

Growth Asset Allocation Model Portfolio Sample

A typical growth asset allocation model portfolio is going to be tailored to the interests and skills of the investor.  A general contractor, for instance, is going to probably hold far more real estate in his portfolio that stock, simply because he has an edge when it comes to finding a bargain and earning a good return on money.  Likewise, an investment banker is going to have a much easier time selecting blue chip stocks or investment grade bonds for holding or trading because of the knowledge has from his primary occupation.

That said, it wouldn’t be unusual or unreasonable to structure a growth asset allocation model portfolio as follows:

Inflation Asset Allocation Model Portfolio

Inflation is one of the most insidious taxes investors face, watching their purchasing power drop each year as a result of governments printing money to finance debt.  For fixed income investors, inflation is an even bigger threat to their standard of living.  That’s why many professional wealth advisers and portfolio managers structure inflation asset allocation model portfolios designed to help combat the destructive forces of inflation over time.  By investing in assets that generate capital gains, dividends, and interest above and beyond the rate of inflation, investors can protect their wealth and earn a good return on their money.

Sample Inflation Asset Allocation Model Portfolios

A typical inflation asset allocation model portfolio would include the following asset class breakdown according to research done by The Wall Street Journal:

Commodity ETF: Low-cost commodity exchange traded funds are designed to put your money to work in tangible goods such as gold, silver, wheat, corn, oil, and other assets that people use, need, and will hold their value regardless of the national currency.

Cash: Cash should be parked in high quality reserves such as FDIC insured bank accounts that earn some interest to offset inflation.

TIPS: Treasury inflation protected securities, or TIPS, are Treasury fixed income investments that pay interested based on the rate of inflation.

REITs: Real estate investment trusts invest in real estate such as shopping malls, apartment complexes, skyscrapers, storage units, and much more.  REITs are traded on the stock exchanges just like shares of common stock and often pay heft dividends.  Real estate is often able to keep pace with inflation because the REIT management team can raise rents every year and the underlying property almost always maintains its value in real terms.

How Pensions and Annuities Change Your Asset Allocation

If you are blessed enough to have a pension or a decent sized annuity with a financially solid insurance company, your appropriate to asset allocation must be entirely different than your less fortunate neighbors.

The reason is because whether you realize it or not, you indirectly have a portfolio worth hundreds of thousands, or perhaps even millions, of dollars worth of bonds, cash, and fixed income securities.  Don’t believe it?  Let me explain and you’ll see the reality.

How Pensions and Annuities Act as Bond Replacements

The fastest way to calculate the “capitalized” equivalent value of your pension or annuity is to take your total annual pre-tax income generated and divide it by 0.04.  For instance, if you collect $1,200 each month from your pension, that works out to $14,400 each year.  Dividing this by 0.04, you get $360,000.  Your pension is paying you the same sustainable rate that you would earn if you had a portfolio of $360,000 in high grade bonds.

Pension Annuities Asset Allocation BondsThus, if you retire with a $200,000 personal portfolio of cash, stocks, and bonds, you shouldn’t use an asset allocation model based only on that $200,000.  You have to take the money you have ($200,000) and combine it with the capitalized bond value ($360,000) for a total of $560,000.  Your decisions about asset allocation and individual asset classes are now more complete because you know that $360,000, or 64.59% of your assets are invested in bonds.  If you were following a passive asset allocation or a balanced asset allocation model portfolio, you wouldn’t want to put any of your $200,000 in bonds because you are, indirectly, already exposed to them.  Instead, you would want to put that portion of your earnings into businesses, stocks, real estate, and cash reserves.