Importance of Asset Allocation & Alternative Assets

In the investment world, 90% of the returns are determined by the asset allocation and remaining 10% returns are determined by the security selection. There are five major asset classes outside of cash: stocks, bonds, real estate, commodities and alternative assets. These asset classes can further be broken down into various subcategories such as domestic versus international (stocks and bonds both), growth versus value (stocks), large cap, mid cap and small cap (stocks), government, corporate and high yield (bonds), etc.

The key to successful investing is the asset allocation and one cannot emphasize enough on its importance to provide relatively steady returns. It is basically about creating an all-weather portfolio. It is designed in such a way that some of the parts of the portfolio out-perform while other parts under-perform. As a result, the overall portfolio provides steady and respectable returns for any given year with minimal amount of standard deviation. The key here is to minimize this standard deviation in returns of a portfolio.

It is a well accepted doctrine in the investment world that says one should have 10% to 20% of their assets in the alternative asset class including real estate and commodities categories aside from usual stocks, bonds and cash. One of the brightest investment minds, Mohamed El-Erian, even suggests putting one third of the portfolio in this asset class. In today's uncertain investment environment, one needs to take a hard look at the overall asset allocation and investments that can be a bastion or a source of visibility, stability and consistency.

The alternative asset class (also known as hedge funds or private funds) strives to provide absolute returns, i.e. positive returns, regardless of market's performance. Further, this alternative asset class is generally meant for high net-worth or ultra-wealthy investors only and it has gotten it's more than fair share of fame as well as blame. The alternative asset class is essentially a pay-for-performance industry, where fund managers can make good or even obscene amount of money (Richard Gere uses a phrase "obscene amount of money" in a film "Pretty Woman".)

Smart and talented money managers capable of delivering as well as me-too types of managers flock to this industry as they are highly motivated by its generous incentive structure. For example, a hedge fund manager, John Paulson (no not that Paulson), amid this world falling apart, made billions for him and his investors during 2007-2008 period.

Equity Market for Next 10 Years

One question on everyone’s mind is how the equities are going to perform for the next 10 years. We just had a “lost decade” ending into 2008. It is only fair to wonder about how it would do going forward. As a matter of fact, just today, my friend’s wife asked me, should she keep everything in cash or continue doing dollar cost averaging as she is quite concerned about the stock market. While historically, equity markets have delivered returns in high single digits including dividends over the last century, there is no certainty that every decade is going to deliver that kind of an average return. Some decades such as 80s and 90s did dramatically well, where as there have been two instances in last century where the stock markets barely budged for 25 years period. That is right; 25 years period.

What juncture are we at now? There are two things near certain. We probably would not see the unprecedented despair and a massacre that we saw in last few months of 2008 again, regardless of how much economy gets bad or how much government, for their fair share, screws things up. That was a wholesale treatment, an obvious shutdown or a freeze-up of credit markets and equity markets in a free-fall, literally. That is unlikely to repeat; extremely small chance of that happening again. Does it mean that going forward is a smooth ride? Not even by a long shot. It will continue to stay rough and may very well get even more painful, however, it is going to be a slow motion movie as opposed to the shock treatment to a mental patient.

The other thing is the next decade seems to bring little more hope than the last one. I am not surprised to see a lost decade that we just had as I did envision that in 2000-2002 time period like many other bears. Had you asked me a question back then, I would have easily said that it does not bring a lot of hope. I am also not surprised by the magnitude of it. While I was one of the minorities to see the train wreck coming, what I have been surprised along with several others who even foresaw this coming is the velocity of that train. A sheer intensity of the storm that gasped everything is what surprised everyone. I in fact imagined a slow motion movie unraveling the ugliness of all of the excesses of the past 25 years.

Next decade could be a continuation of the last decade, however, I doubt it, given the fact that the valuations, though not super-cheap, are below historical average. The downside risk still remains at further 30% due to dire effects of de-leveraging and broken balance sheets of all constituents: households, businesses and governments. Whether the protracted downturn materializes in one, three or five years is anyone’s guess. A lot is going to depend on the actions of U.S. Government and Federal Reserve. While I am optimistic in their actions, unfortunately, I do not have a lot of hope there. This means that we may be in it for a rough ride. However, chances of hitting high single digit returns during the next 10 years are better than 50-50.