Some Thoughts on Portfolio Allocation

nvesting is a game. Like all games, there are rules. In order to be successful at the game, one must both understand and follow the rules. Most importantly, as a player of “the game” one needs to determine where it is that they excel best. When the rules of the game change, players must adapt or be retired to the history books as others who do adapt take over the spotlight of present. If we can agree that investing is a game, then we should also agree that the Fed is the Commissioner of the league. The Fed makes the rules, and as they change, you must react accordingly.

So what are the “rules” and how do we adapt to them? When I talk about rules I am not referring to insider trading laws or anything relating to criminal acts/law. I am referring to market manipulations by the Fed such as artificially low interest rates that impact portfolio performance and allocation decisions. Determining the best short term and long term portfolio allocation is actually quite simple given the current rules of the game. The Fed has promised to keep interest rates low through the end of 2014. Here’s what this means to you.

First, remember the simple rule that fixed income prices and yields (i.e. interest rates) are inversely related. As yields rise, prices fall and vice versa. Second, history has shown that both real estate and stocks perform well during inflationary periods (as do commodities like gold, oil, platinum, etc) and perform poorly in periods of deflation. The previous two rules are basically all you need to know to help in constructing your portfolio of investments, at least on a macro top down level (this article will not help you pick specific winners but rather give you the frame in which to operate in deciding what classes to focus on when picking specific winners). I am more of a bottom up guy, but it is vitally important to understand what the rules of the game are before going “bottoms up” into the investing world (pun intended).

Yields are staying low until 2015 assuming the Fed keeps its word. This is a fairly safe assumption because a lack of trust in the Fed or deterioration regarding their word would cause chaos in the markets in the form of extreme prolonged volatility thanks to uncertainty. The Fed knows this and is likely to keep their word. If yields do not rise than fixed income prices cannot fall. I am not saying the 10 Year won’t go to 2.5% and prices fall a little, but there is definitely a floor on bond prices for the short term. For the next couple of years owning fixed income is ok. It’s not great, but it is ok. In the short term stocks are somewhat risky given deflationary pressures in Europe and the mess they have yet to fix and fixed income is just ok. Now is not a great time to be investing in general if you have your eye only on the short term.

While bond prices are being artificially propped up with printed money from the Fed (call it monetizing the debt, quantitative easing, whatever you prefer), it’s tough to pick up yield in the bond market. As the cap on interest rates is lifted in a few years bondholders will get decimated by inflation and rising yields (falling prices). The U.S. has to default on its debt via inflation as it did after World War II since we are far beyond the point of being able to repay our debts in full. Fixed income will get destroyed during this process. Yields have to rise, but they have to rise slower than inflation in order to inflate away the debt (they need to be manipulated by Fed bond purchases creating artificial demand). This is most likely to happen once the deficit disappears and we have moved our short term debt out to long term (already started doing this with Operation Twist) so that we don’t have to roll debt at higher rates due to upward pressure on rates thanks to inflation.

Stocks, real estate, and commodities will outperform. In the following paragraph I will describe my longer term top down plan and you can make slight adjustments to your own given your own appetite for risk, investment horizon, financial situation, etc.

I will use the next few years to pay off student loans and then save money for a down payment for a house. Right around 2015, ironically after I have my debt repaid, I am going to lever up as much as possible locking in a 4%-5% rate as I put my savings toward a down payment on at least one property. Inflation over the long term (as of now that looks to be 2015+) is inevitable. We have a FIAT currency and absurd amounts of debt. Real estate helps to protect purchasing power. Also, as inflation rolls on, my income will increase to match it while my mortgage payments stay fixed. This is situation is awesome for borrowers as you just become a profitable bank in a sense. Banks borrow money at one rate (the rate they pay depositors) and lend at a higher rate to people who need the cash. The profit they make is the spread between the two rates. When I lock in my 4%-5% rate, not only will the mortgage payment as a percent of my income decrease over time with inflation, but also I will be building up equity while capturing that spread. I pay 4% and I “earn” say 6% or whatever the rate of inflation is at the time.

In addition, to levering up and buying up real estate, I will keep 20% of my wealth in gold. Gold rises when the dollar declines in value (i.e. when inflation is present). The dollar is artificially strong now because the Euro is such a mess and investors have nowhere to hide /park their money. Gold should continue to outperform the market over the next few decades. I will not own any fixed income investments from 2015 on. I will put the rest of my money in what I perceive to be undervalued securities based on my analysis of the companies and their stock price at the time I invest. Remember you can have a great company, but a bad stock if it is overvalued so you need to look at it in both fundamental and relative terms.

In conclusion, start running away from fixed income, but don’t necessarily rush into stocks just yet. They have had a nice run up recently, Europe is still a mess, and the most severe cuts and reforms to spending and the economy usually come one year after an election for obvious political reasons (tough to get elected in a bad economy). Some great long term opportunities are forming the market, be prepared to capitalize on them!

A side note: I will publish that article on risk I mentioned earlier. Our current understanding of risk is flawed at best as it pertains to the various asset classes and managing a portfolio. The theme will revolve around that fact that risk as measured by standard deviation assumes that returns are normally distributed which they are not and also that risk can be upwardly biased. Would you consider a fund that is twice as risky or volatile as its benchmark or “the market” (S&P 500) to be risky if over 10 years it never had a down year and the volatility only came from extreme positive returns? I know I wouldn’t. Even services like Morningstar fail to adjust for this. More on that topic coming up in a few days/weeks.