A question that always comes up, regardless of age, is how do I allocate my money once I start a savings program? The question soon morphs into how do I allocate my money after I have been saving for some time? I believe in simplicity. The combination of simplicity with mathematical elegance leads to a powerful solution that is within the grasp of most investors and most importantly, because it is comprehensible has a high likelihood of sustainability. This simply means that if you design a savings plan that is too complex, I doubt it will work. You can read A Rebalancing Tale for an example of a simple elegant solution. So when asked, how to allocate money at the start of a savings plan I always answer, the same way you would allocate money towards the middle or the end of a savings plan. This implies that selecting the initial allocation must be very important. It isn’t. As we learned in A Tale of Perspective, initially the most important thing is to start a savings program, regardless of how you allocate the money. However, your allocation takes on importance soon thereafter so it doesn’t hurt to give it some thought at the onset of a savings plan.
We have learned that asset allocation and dollar cost averaging are critical to building wealth. In fact they are the only two things required to build wealth. Bill Gates saved his money and invested it or allocated it into Microsoft stock. Warren Buffett saved his money and invested it or allocated it into multiple investments. Oprah Winfrey saved her money and invested it or allocated it in branding herself. If you look at anyone that has ever built wealth, of any magnitude, they have these two things in common. They saved money and invested it or allocated it. Which one is more important? Some would say that without dollar cost averaging you wouldn’t have to worry about asset allocation because you would never have money to allocate in the first place. But assuming that you have taken the leap and have decided to enter into an investment program, then asset allocation is more important than dollar cost averaging and it is easy to see why. Amongst the two titans, the first being dollar cost averaging or a consistent savings program and the second being asset allocation, the winner is asset allocation.
To understand how the logic works, we must first start with the standard dollar cost averaging model where a person invests a set amount of dollars into an investment program for a set period of time. In this case, let’s assume that the person invests $100/week for the foreseeable future.
In the above example this person invests $100 in the first week and it represents 100% of their total investment. In the second week they invest $100 and it represents 50% of their total investment. In the third week they invest $100 and it represents 33% of their total investment. In the fourth week they invest $100 and it represents 25% of their total investment. By the 100th week the $100 weekly investment represents just 1% of their total investment. I would suggest that by week 100, this person had better pay more attention to how they manage or allocate their previous 99 contributions than how they invest the 100th contribution. Thus is the case for asset allocation over dollar cost averaging. Both are necessary but one is clearly dominant. As a final tribute to the dominance of asset allocation, imagine the day where you stop contributing to your savings plan. At that point, we can call it retirement or once you have achieved a wealth objective, you no longer save money. At that point asset allocation represents 100% of the equation.
Since it’s obvious that asset allocation is more important than dollar cost averaging and becomes more important with each passing week, I think it would be a good thing to establish an appropriate asset allocation in the first week that one embarks on a savings program. You certainly need to have an asset allocation by week 100, why not in week 1? We know that over time equities outperform fixed income investments so it’s not unreasonable to assume someone that is trying to accumulate wealth would choose a very aggressive allocation to equities. But since this is a behavioral tale and we know that people will consistently make the wrong investment decisions let’s look at 4 different portfolios and see which one is the type of portfolio that someone that starts a dollar cost averaging program is most likely to follow. You can read A Portfolio Tale to see what I consider the type of portfolio that my experience tells me people can stick with through bull and bear markets.
Since it’s my belief that the investor is an integral part of their portfolio I suggest that the best asset allocation is one that the investor can maintain. This means that it’s probably something less than 80% equities. I say this because I’ve observed the way investors behave and recognize that the probability of staying with an investment strategy increases as the volatility of a portfolio decreases. The corollary to this statement is that the probability of staying with an investment strategy increases as the rate of return increases. Simply put, there is a happy medium. Take a look at the following table to learn something about how you view a portfolio. If you were investing $100 per week into an investment program, which of the 4 portfolios would you most want to represent the results of your portfolio. In other words, which portfolio do you like better?
A Behavioral Table
Which portfolio did you choose? On the surface you would choose portfolio 1 or 2 since after 21 months you ended up with the most money. However, not everyone does. They often choose portfolio 3 or 4. How can this be? We are all taught to maximize our wealth. Clearly portfolio 3 and 4 are inferior in that regard. Why do people gravitate to these two? There is a combination of behavioral terms for this but for purposes of this tale I like to call it “The Month 22 Effect.” People like to interpret past data and project it into the future and they like to examine past results and think they will repeat into the future. When they examine the 4 portfolios this is what they see.
When they look at portfolio 1 they see that it was worth $2,821 at one time and has been losing money recently. They don’t want to lose money in month 22 so they might avoid this portfolio. When they look at portfolio 2 they see that it lost almost 50% of the cumulative investment by month 16. They see that it’s been going up over the last 5 months but they still see potential danger. Most like it better than portfolio 1 because it has been going up recently but they don’t like the potential of a 50% loss in the horizon. Portfolio 3 got off to a slow start but has made more money than what was invested and shows good consistency and people reason that it will start going up soon. Portfolio 4 got off to a good start, lagged for a while then went up strongly. The beauty of portfolio 4 is that it is the only portfolio that every month has more money than the month before and has been making money at a good clip in the last few months. People will most often choose portfolios 3 and 4 over portfolios 1 and 2 despite the fact they didn’t maximize wealth.
This example in a nutshell is how people make asset allocation decisions at time zero or before they actually invest in or experience the results of one of the 4 portfolios. They project a certain level of behavior and think they will be able to maintain the portfolio they selected. However, these decisions go right out the window once they actually own one of the 4 portfolios and they start losing money. What they thought they could maintain they no longer maintain. They exit their strategy at typically just the wrong time. The wise investor recognizes their human tendencies. They recognize that they are an integral part of their portfolio and that the fear of losing money is greater than the exhilaration of making money. So, when confronted with reality they always prefer portfolio 3 and 4 followed by portfolios 1 and 2. In practice people don’t like the volatility of portfolios 1 and 2. They prefer something that gives them a smoother ride.
Over the years I have presented my clients with this very same type of question to determine which asset allocation is best for them and to get a better understanding of their risk tolerance. I learn much from their answers and this is one of the main reasons that I can safely say that any advisor that manages a family’s money should incorporate a behavioral component into their portfolio composition. A behavioral portfolio that I think works can be read about in A Portfolio Tale.
For those that are curious, portfolio 3 has half the money invested in portfolio 1 and half the money invested in something that doesn’t pay any interest but doesn’t move up or down either; the equivalent of a money market fund that pays 0%. Portfolio 4 has half the money invested in portfolio 2 and half the money once again invested in something that doesn’t pay any interest but doesn’t move up or down either. This tells me that reducing the volatility or movement in a portfolio is very important to people. We started this tale by saying that the asset allocation should be set initially and this tale shows that in my opinion there is a strong behavioral case to be made for including safe investments in that allocation. Do it. Include safe investments in your asset allocation.