Asset Allocation: The Big Picture

In response to Finance Girl's request I'm going to do a series of posts on my asset allocation. Today's post will look at how I think about the overall big picture and then the next few posts will drill down to the level of individual investments. Most bloggers out there are either stock pickers, traders, or index investors though there are more complex allocations too. My approach is one of those more complex ones. This is how I think about asset allocation at the highest level:



You're seeing my position when I have almost no active trading positions. Let me explain each category in turn:

Passive Alpha This is a bit of a misnomer - as these funds are invested with active managers - these positions are passive from my point of view because it is largely buy and hold. Included in this category are closed end funds, financial firms (including Berkshire Hathaway and Hudson City Bank Corp for example), REITs etc. The point of these investments is to try to generate returns that are relatively uncorrelated with the stock market and uncorrelated with my own trading. That's why I call these investments "alpha". But as you can see I estimate that these investments actually contribute 0.138 points towards my portfolio's total beta. They aren't pure alpha by any stretch of the imagination. I include the financial firms in this category because really a bank, for example, is involved in investing funds in loans to a diversified portfolio of customers. So in some ways it's similar to a closed end fund. There are also fund management companies in here. In the long-run I'd like to increase the proportion of net worth invested in this category from 22% to 40-50%.

Beta Another misnomer - as all the mutual funds in this category are actually actively managed. So they aren't pure beta. The reason they are all actively managed is something of a legacy of the past - and there still aren't many indexed mutual funds available in Australia. In the future I would probably add some ETFs in this category, but as I want to reduce the allocation to 40-50% of net worth, this won't happen any time soon. You'll notice that this "beta" actually contributes little beta to my portfolio. I adjust my holdings in this category over the course of the four year stock cycle. At the moment I am as conservative as I will get and most of what is in here is in fact bonds rather than stocks. I try to hold these mutual funds for at least a year to get the long-term CGT rate in my taxable accounts. The largest part of these funds though are in my retirement accounts.

Trading This includes cash in my trading accounts and open trading positions. This is where I actively try to generate alpha in my portfolio. My policy is not to add any more money to my trading accounts until I can show that I have recaptured the losses I generated earlier in my trading career. At the beginning of the last week there were about $10,000 of losses to recapture. Now we are back to about $13k. The beta of this category can be either positive or negative. My most extreme positions add or subtract about 0.7 beta to my portfolio - taking me from fully long to net short. Trades are generally directional bets on the market and most are held from 1 day to 1 week, though there are also occasionally longer-term trades.

Industrial Stocks This is the extent of my "stock-picking". Any non-financial individual stock is in here. I don't think it is easy to pick stocks that will outperform (at least not for me) and, therefore, I don't do much of it. If I see something that does look good I'll do it. In the past I had much more allocated to this. In the future, I'll probably have even less.

The final two categories are simpler - Liquidity is cash in non-trading accounts - 3% is around $12,000 - this isn't an emergency fund in any sense though. I use credit cards for emergencies. It's just money I haven't decided yet to allocate to investment or spending. Borrowing - the basic idea is that I am 100% invested and borrowing funds to trade with. You'll see the two categories have about the same allocation. Where possible, though, I try to use products with embedded leverage (futures, options, leveraged mutual funds) rather than borrowing explicitly as the interest rates are generally much lower than I can get myself.

My portfolio is also invested in assets associated with different currencies. In the first few years after I returned to the US I sent a lot of savings back to Australia as the Australian Dollar was cheap. Now that the Aussie Dollar has risen a lot I am accumulating all savings in the US and will begin transferring dividends and distributions I receive in Australia back to the US. In the long-term I would like to bring down my AUD allocation to around 40-50% of my net worth. The other category includes some global closed and mutual funds that are not hedged back into a single currency such as AUD or USD.

For another view of my asset allocation you can check out my NetWorthIQ Profile.