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Asset Allocation: A Balance for Success

Asset Allocation: A Balance for Success
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As we've discussed at length, the acquisition of productive, income-generating assets is vital for successful wealth management; this includes both owning productive real assets (like equities) and lending (through instruments like bonds). But how should you divide your savings among these options? What percentage of your wealth should you allocate to each?

Productive real assets are particularly appealing as they generate income based on the value of the goods or services they produce, making them a solid hedge against inflation. Consequently, a substantial proportion of your savings could be wisely allocated to this asset class. This would maximize your future return while maintaining broad diversification to protect your wealth over the long term. Yet, owning productive real assets such as shares in public or private companies, or real estate, can introduce a measure of short-term liquidity risk. This can become problematic if you need immediate access to your savings.

That's why it's prudent to allocate a portion of your wealth to bonds and cash as well. Due to the predictability of future cash flows in hard currency, these assets exhibit much less volatility when converting to cash. In other words, high-quality bonds tend to be less volatile than equities.

Let's use a couple of hypothetical examples to illustrate asset allocation strategy. Consider Alex, a 45-year-old legal counsel working in a stable organization. He earns a regular salary that exceeds his expenses and saves consistently. Alex enjoys his work and has no plans to retire or change jobs anytime soon. Thanks to his saving habits and job stability, he has accrued a significant amount of wealth and continues to add to it through his net savings. Given his circumstances and minimal need for liquidity, Alex invests most of his assets in diversified equities, thus capitalizing on the potential long-term returns that broad company ownership offers. He also holds enough cash for emergencies, equivalent to six months' worth of expenses.

Hana, in contrast, owns a waste management consultancy. Although her company is usually profitable, the profits are inconsistent. Given the nature of her business, Hana wants to ensure she has a reliable income from her investments if her company experiences a downturn. While she has also accumulated a substantial amount of wealth, her passive income from her investments alone is not sufficient to supplement her current lifestyle. Hana prefers assets that yield steady passive income. At the end of each quarter, she reinvests any excess savings from her business profits and passive income, to grow her capital base and increase her passive income. Due to her circumstances, Hana not only maintains an emergency fund equivalent to six months' expenses but also invests in bonds to mitigate portfolio volatility. This allows her to liquidate assets if necessary without major losses. Hence, she divides her investments into 40% equities and 60% bonds, achieving a balance of inflation hedging from equities and income stability from bonds.

These examples demonstrate how personal circumstances and objectives influence asset allocation. However, the same long-term fundamentals are key to everyone's financial success.

Before concluding, let's reflect on some important considerations:

  1. One of the most common mistakes is hoarding cash due to uncertainty. There's a reason why professional institutional investors such as sovereign wealth funds rarely hold more than 5% to 10% in cash: cash lacks certainty of future returns and historically lags inflation—a feature, not a bug, of our global economic policy.
  2. At the point of retirement or achieving financial independence, you'll want your wealth to provide a passive income without depleting the principal. It's best to start working towards this goal early, reinvesting any excess passive income and net savings.
  3. When determining your asset allocation, be clear about your current financial circumstances and define your financial goals, both short-term and, crucially, long-term.
  4. It's always wise to seek the advice of a professional. A good financial advisor can provide invaluable guidance in your wealth management journey.