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A Recipe for Asset Allocation:

Now I’m no Martha Stuart, but I do know that a good recipe tends to work time after time because it’s not altered drastically in any way when you follow the instructions and proportions of ingredients. Over time you may decide that small modifications are needed to make improvements or that your tastes and/or dietary needs have changed. The nice thing about simple recipes is that even someone with no experience in a kitchen can usually follow the instructions well enough in order to have it turn out fairly well.

Asset allocation really isn’t all that different from cooking when you think about it. The ratio that you hold assets in depends on personal preference and taste, it changes over time with your lifestyle and if the ingredients aren’t in the proper ratios (or included at all) the outcome tends to be a disaster. You can try to make bread without flour or water, but the odds are that it’s not going to work out very well for you.

There will be times when you add new flavours or ingredients with the intention of improving the recipe and adding some flair, yet one of two of the additions might not match and then you’re left with something less desirable than when you started. At other times someone will tell you what’s in a recipe and you turn your nose in disgust until you try it and like what you find. After a period of time a recipe becomes so automatic that you hardly take notice of specifics because you know what works and don’t bother making any changes. And once or twice everyone has tried to hurry, take a shortcut or substituted for quality in order to save time or money and acknowledged afterwards they knew it wouldn’t turn out the same.

It’s important to note that not all investors believe in asset allocation and not all cooks follow a recipe but instead fly by the seat of their pants. If either of those works for you in any way then there’s no need to change your strategy. But for the majority of investors (and cooks) following a recipe is an integral component of what makes them successful and they only deviate from that focus when they have good insight that the risk will pay off.

My point:

Over a recent conversation with a friend (Nurse Steve) I was asked the following question:

(Some information neglected r/t confidentiality)
“…I am not exposed to any U.S funds right now because at the time s**t was hitting the fan. Whether or not that was a wise move, I don’t know, except my emotions said ‘hold off’ because in my mind, I have the power to do so with my almighty self-direct RRSP. Do I buy my *** ** ***** fund and ** ** index now? Hold off? I’m waiting for an epiphany to occur, but in the end I’m confusing myself even more…”

This situation is likely not very dissimilar to that of many investors pondering their investments in US mutual funds and individual equities with the recent media attention of recession, massive subprime losses and complete whacking of interest rates. I can understand the apprehension many investors (including my friend) have regarding whether to buy, sell or hold their US investments, but I’ll offer some insight into what I’ve shared with him and others.

US GDP as a percentage of the world was approximately 27% in 2006 (Source: IMF) and although on decline in recent decades it still makes up a sizeable amount of the world economy. Virtually all currencies have risen against the USD in recent years, the housing market is in recession, the consumer is likely heading there shortly (if not already there), financial companies are reeling from billions in losses and the fiscal health of the country has been thrown into turmoil by eight years of mismanagement by the current administration.

It’s no wonder that investors are fearful of where and how to invest. If you have a short-term horizon for your investments then you likely want to stick with relatively safe investments in cash, fixed income and high quality equities. If you have a long-term investing horizon (like Steve) then your view of this extended turmoil could be one of measured opportunity. I say measured because no one really knows what the future holds and like any situation you need to put the information available into the proper context.

So asset allocation is like a recipe; you need to use the right ingredients or what you’re trying to make (for better or worse) won’t turn out the way that you intended. So take my friend’s situation: he has a desired asset allocation for a long-term investing strategy yet has a hesitation about where to place some funds due to the under-performance for that proposed segment of his portfolio. This is obviously a normal reaction to investing because no one enjoys losing money – you’re investing with the intention of appreciating your capital. But as an investor you have to have the discipline to stick to your recipe if you’re going to enjoy success over the long-term.

The entire point of the couch potato portfolio is that in years of poor performance an investor will invest a higher percentage of his/her capital into those under performing funds because of their relative weighting in each asset class. Over time this enables an investor to buy low and sell high.

Question: If today you could go back in time and had the opportunity to invest in the Canadian index in late 2002, would you do it and why?
Answer: Yes, because you would have been buying at one of the low points in the market and enjoyed a nice ride to the top of the bull market.

The US component of my friend’s portfolio is no different than this example. No one will know with any certainty whether that investment will perform the same, but over time the principle remains the same. If you plan to contribute to your investments over a long period of time then an investor should view market declines as opportunities to buy their investments cheaper relative to future returns and enhancing your ability to compound your investment. You might have an opportunity to buy an investment cheaper or more expensive in future months but the key to what makes this strategy work is that you likely can’t tell the future so you should make the most of your opportunities and stick with your plan.

If your allocation for US investments is 30% and you decide instead to trim back to 25% then that is your decision to make and no one can blame you for protecting your capital. But avoiding certain assets altogether in challenging market conditions is usually a bad idea because timing your re-entry back into that asset class can be difficult and you likely would have made just as much (or more) by remaining invested in some part than not at all.

The recipe metaphor serves as an important lesson by showing individuals that sometimes ingredients can’t be substituted or eliminated for other components if you’re trying to accomplish a very specific goal. A few grams here or there won’t make a whole lot of difference in the end, but eliminating that ingredient all together is likely to have negative results more often than a positive outcome.

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