Sunday, February 21, 2010

Asset Allocation for the Future

Asset allocation strategies are based on simulations of past performance. The theory is that the future will mirror the past. If only that were so, life would be so much more simple. The world is changing and if one is to be a successful investor one is going to have to change with it. In the past a conservative allocation strategy has been to allocate about one half of ones assets to fixed income investments and about one half to equities. The assets allocated to equities have generally been recommended as being 75% invested in US equities mostly to large cap equities and perhaps 25% to foreign equities or perhaps even less. The logic behind this distribution is that fixed income is a more stable investment than equities tend to be and US equities are more understandable than foreign equities and better regulated.

Of course no one can predict with any certainty what the future will hold, but one can certainly make some reasonable postulates based on trends that are apparent.

Trend #1 US budget deficits are increasing rapidly with virtually no end in site requiring the government to borrow more and more money.

Trend #2 Production is leaving the US for less expensive economies.

Trend #3 Economic development is shifting from the western world to the countries of the east.

Trend #4 Many US corporate CEOs are more interested in feathering their nests than in managing a thriving business.

These trends suggest that interest rates will rise dramatically in the future as the world's largest borrower runs out of people willing to risk lending money that most likely will not be repaid. The world economic shift taking place suggests that future investment options should also shift with them. And finally they suggest that one should avoid investing in companies paying their CEOs extravagant salaries and bonuses. They do not have their investors' best interests at heart. They have their own best interests at heart.

Although these trends appear almost self evident, nothing in this world is deterministic. Everything is probabilistic. There is always a chance that things might not be as they seem. And there is always the chance that things might change. Supposing for example that the US government were to pass a new tax law taxing incomes of over $1,000,000 at a 90% tax rate. Such a change might also change the management styles of many US corporations.

So the question is what should an asset allocation look like for the future world economy. To me it seems that one should allocate more assets to equity investments than has previously been recommended. For a conservative investor that would suggest no more than 20 to 30% in debt instruments if that much. Looking towards the future debt instruments seem to be an investment that will not fare very well. For a less conservative investor they might be avoided all together. One might ask why as much as 30% for a conservative investor if in fact interest rates are expected to rise. Why not avoid them all together? Well, the problem is that during periods of rising interest rates equities tend to perform even worse than debt instruments. Most corporations run on borrowed money, not all but most; and if borrowing costs increase their profits suffer as a result. Banks will be especially vulnerable because they borrow short term to lend long term and if they have lent a lot of long term money at 5% interest and they have to pay 6% short term, one can imagine what the impact will be. Another consideration is if one is investing in debt instruments one should avoid the longer term instruments--those over about 5 years in duration. The longer term debt instruments will be the ones that suffer the most during a rising interest rate environment.

The remaining question becomes how should one invest ones equity allocation. Certain companies in the US will do much better than others in the future. Companies with a strong balance sheet will be at a distinct advantage over those loaded with bank loans and short term debt. Those that had borrowed long term at previously low interest rates will also be at a distinct advantage. Companies with a large amount of foreign sales will also be at an advantage as they convert foreign currencies back into US currencies and as they service economies growing more rapidly than the US economy.

What are some examples of these types of companies? Coca-Cola is one such example. More than 75% of sales is outside of the US. Long term debt of the company is less than 20% of total capital. 3M is another such company. 64% of sales is outside of the US. Long term debt is less than 30% of capital. Multinational companies should be relatively safe investments if not exciting. A non-US company of this type is Nestle, a Swiss company. The question of what percentage of ones assets should be invested in these types of companies is open to some speculation. Perhaps 50% of ones equity portion, perhaps more or less. Despite what the future holds these type of companies should do well provided they continue to have good management.

The Asian countries, Latin American countries and Australia are those where future growth is most likely to occur. Some companies in these countries are traded in the US. Another option is to invest in an index fund or mutual fund that invests in these countries. There are many to choose from.

Personally, I am not in favor of many index funds as investment vehicles. They have one glaring flaw. That is that most are capitalization weighted which means that they are not a diversified investment option. Index funds concentrate most of ones investment in a few very large capitalized companies. But they are an option. On the other hand mutual funds also have one glaring flaw. They have to pay realized capital gains annually on which one is taxed. Index funds generally do not suffer greatly from that flaw.