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Views on long term investing
Old 10-28-2007, 02:54 PM   #1
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Join Date: Oct 2007
Location: Raleigh
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Views on long term investing

Not long ago most families invested little in stocks, even though they have provided superior returns in the long run. More recently, many families have plunged significant portions of their savings into narrow sectors of the market, or follow the advice of financial commentators who fill the airwaves with advice on choosing the latest hot stocks.

A sensible, orderly asset allocation strategy dispenses with luck, market timing, and other "buy low, sell high" sleights of hand, and is less concerned with how investments perform individually than how they perform as a group. Like many others, I am a strong believer in diversification, but its important to understand and use the correlation of asset classes in selecting the right mix of investments to achieve a superior return over the long term, while at the same time managing risk.

The correlation of how asset classes in a portfolio tend to move up or down together, is very important to understand. All other things being equal, a negatively correlated asset is more powerful to include in a portfolio due to its ability to reduce volatility by adding an asset class that tends to move in a countercyclical pattern compared to the other components of the portfolio. In addition to minimizing risk, reducing the volatility in a portfolio causes the rate at which money compounds to go up. Because they have dissimilar patterns of return, if you are patient and continue to own the underperforming asset class, it tends to eventually take its turn in the sunshine again. By having payoffs at different periods of time, you smooth out your returns and create a better overall rate of return. You tend to win both in terms of risk reduction and return enhancement.

Most traditional portfolio strategies tend to focus on U.S. stocks, bonds, and cash, whereas it is important to focus on all four equity asset classes: U.S. stocks, non-US stocks, real estate and commodities. The percentage of allocation to each of these asset classes is less important, as long as each class has a significant (minimum 10%) allocation.

The allocation between the equities classes, bonds (corporate/government and both investment grade and high yield) and cash (money markets, bank accounts, CD's) is much more a function of ones own personal financial situation and risk tolerance. My own allocation mix would be viewed as very aggressive (70% equities, 20% bonds, 10% cash). However, over the long term investors should not ignore the historically proven much higher return that equities provide versus bonds and cash. Unless one is very pessimistic or truly believes that capitalism is in a long term decline, then I recommend limiting the allocation in bonds/cash to an amount necessary to avoid forced selling during the (relatively short) bear markets in stocks. Fundamentally, this should be done by deciding how much you're willing to pay (intentionally reducing the opportunity for higher returns), to avoid sleepless nights when you incur unrealized investment losses over a short term horizon.
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