Guidelines for Strategic Asset Allocation
By Bill Addiss | Updated: August 1, 2019
The ebbs and flows of economic strength and weakness are called economic cycles. A fundamental aspect of strategic long term investing is how asset allocation is managed throughout these different economic cycles. Investors who are knowledgeable about the basic asset types and which perform best in what stage of the cycle have the opportunity to improve their results by, for example, increasing stock holdings or investing in cash assets as the economy dictates.
Understanding Economic Cycles
The recovery stage is marked by growth and strength. Gross Domestic Product (GDP) is rising, unemployment is lowering, factories are producing more and consumers are purchasing more. Interest rates and stock prices are also starting to rise to reflect the stronger economy and corporate growth.
As the saying goes, all good things must come to an end and the peak is the beginning of the end of economic growth. As prices reach their top out point consumers begin to cut back on expenses and soon supply exceeds demand, leading companies to produce less and, therefore, profits to decrease. What all of this means is that GDP growth is slowing down which typically also results in The Fed lowering interest rates. Frustratingly enough, it is usually only with the benefit of hindsight that investors can look back and identify at what point the economy actually reached its peak, but there are signs to watch out for.
The signs of an economic slowdown are usually very apparent once it has begun. Corporate profitability and stock prices are retreating, interest rates are declining, unemployment is rising and GDP growth is slowing. A contraction in the economy can be brief but there is also the possibility of an extended lull resulting in an economic recession or depression.
This is that point where the economy is now as weak as it going to get and it is once again poised to enter another recovery phase. As with the peak, it is only with the benefit of hindsight that investors can look back and identify when the bottom of the trough was reached.
With a basic understanding of the economic cycle, it is now possible to discuss a strategy for asset allocation. It is certainly important to remember that everyone’s situation is unique to their individual needs for liquidity, the amount they seek to invest, how long they are looking to invest for and the amount of risk they are comfortable with. However, there are some generally accepted principals when it comes to asset allocation that investors could follow. A prudent long term investing strategy would dictate that investors adjust their allocation of assets as the economy goes thru its cyclical changes.
When to Adjust Allocation of Assets
When the economy is strong, as in a recovery phase, the stock market tends to perform well and it could certainly make sense to allocate more investments into stocks. That means reducing holdings in other assets like cash or bonds accordingly to take advantage of the potentially higher market gains.
Conversely, in a slowdown or contraction phase when the stock market would likely be underperforming, it could certainly make sense to decrease holdings in stocks and invest in cash alternatives and other safer investments like bonds. This strategy could allow investors to avoid possible catastrophic losses in a falling stock market while still earning some interest via less risky investment types.
Investing in Cash
The term investing in cash does not refer to stashing stores of cash under the mattress, for safety reasons alone that would be unwise. Nor does it mean depositing a bunch of money in the bank as that would be largely uneconomical. Holding actual cash (even in a vault somewhere) means you are earning little to NO income on that investment; it is essentially a dead asset. If there is any inflation rate during the period of time the money is being stored, it is actually losing purchasing power! Instead, investing in cash refers to investing in cash alternatives which offer the benefits of safety, liquidity and earning some rate of interest.
3 Types of Cash Alternative Investments
Money Market Funds:
A money market fund is a mutual fund which invests in short term investments. It offers the investor liquidity, as investors can sell and receive their funds within a day. The portfolio manager invests in liquid, short term vehicles and strives to maintain a stable value of $1/share while at the same time offering income to their investors. It is worth noting, although these funds are offered by brokerage firms, mutual fund companies and banks, these investments are NOT guaranteed or insured like a bank deposit would be.
The US Treasury Department offers a variety of short term T’Bills on a regular basis. Weekly, the treasury offers investors T’Bills with maturities of one month, three months, six months and one year. These investments are backed by the full faith and credit of the US government. Although they can be purchased thru a broker, T’Bills are also offered to investors directly by the Treasury department, not requiring the investor to pay any brokerage fees or commission. To learn more about this opportunity and see the schedule of upcoming offerings, check out: www.treasurydirect.gov.
Certificates of Deposit, (CD’s):
Banks issue savings certificates to investors as a way of borrowing money. These instruments are offered in a variety of maturities usually ranging from one month to 5 years. When looking to invest in CDs, it is important to check with different banks as the yields offered can differ dramatically from bank to bank. Another benefit of this investment is that CDs are insured by the Federal Deposit Insurance Company ( FDIC ) for up to $250,000 per individual/per bank.
As illustrated, the asset allocation model that works in a recovery phase is going to be different than in a contraction phase, therefore, managing assets should be an active process. If you’d like to learn strategies for proactive investing, get started by signing up for a free half day class.
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