Asset Classes For Portfolio Diversification

“Don’t put all your eggs in one basket,” is a traditional idiom that warns us not to risk everything on a single venture.  If you divide your eggs into two baskets, and one basket is dropped, you have still preserved half your eggs.  Applied to investing, this strategy is referred to as diversification.

Many years ago, when I was in the financial planning business, “diversification” was interpreted to mean, “Divide your investments between US stocks and US bonds and make sure the stocks cover all the market sectors.”  Today, even the average investor can be much more sophisticated in portfolio diversification.  Using Exchange Traded Funds (ETFs), any investor can diversify much more broadly than was possible in the old days.

For example, you shouldn’t limit yourself to only US stocks and bonds.  It is very easy to invest in foreign stocks and bonds using ETFs.  Going back to our egg-harvesting example, international diversification is analogous to, “Even if you have your eggs divided into two baskets, don’t let the same person carry both baskets.”  This way if one person (country) stumbles, you have another person carrying some of your eggs.

How to Diversify

The diagram below illustrates how I approach asset diversification.  It may be a little complicated for some people, but it illustrates my view of the investment universe.

Asset Diversification

As you move from left to right in the diagram, each box represents a filter or a categorization for the asset to the left.  For example, both Stocks and Bonds are first divided into either Domestic or Foreign.

To be more accurate, I should have called “Stocks” “Equities” because further to the right I divide them into Stocks, Funds/ETFs or Options.

For each Domestic Stock, I categorize it by my goal for that stock.  My goals are either Growth, Income or High Risk/Reward.  Both Growth and Income Stocks are intended to be held long-term, while High Risk/Reward Stocks probably can’t be held for very long because they are volatile and were purchased with the hope of a good short-term gain while being watched carefully.

If a Domestic Stock can’t provide me with Growth, Income or the prospect of a short-term gain, I shouldn’t own it.

Foreign Stocks are first classified as Developed Markets or Emerging Markets before assigning each Stock to a Sector.

Second in importance, after the investment goal for a Stock, is the business Sector it falls into.  Most often, you see sectors categorized in a couple of ways:

Morningstar Sectors S&P 500 Sectors
Business Services
Consumer Goods Consumer Staples
Consumer Services Consumer Discretionary
Energy Energy
Financial Services Financials
Health Care Health Care
Industrial Materials Materials
Hardware Industrials
Software Information Technology
Telecommunications Telecom Services
Utilities Utilities

These categories are too granular for me.  I divide stocks up into eight categories:

My Sectors

  • Technology
  • Consumer
  • Health
  • Energy
  • Financials
  • Industrials
  • Utilities/Telecom
  • Commodities

I group Consumer Staples, Consumer Discretionary, Consumer Goods, Consumer Services and Media all together into “Consumer.”

I also group Telecommunications Services (e.g. AT&T, Verizon) and Utilities (e.g. Con Edison, Duke Power) into one category.  The rationale here is that they are both semi-regulated services for the consumer that bill monthly and usually pay dividends.

There is one obvious overlap/redundancy in the diagram.  One of the Stock Sectors is “Commodities” and one of the major asset types on the left is also “Commodities.”  Following the Commodities major type all the way to the right shows that one of the three ways to invest in Commodities is Producer Stocks.  These Producer Stocks also fall into one of two Stock Sectors: Commodities or Energy.  The reason I have this in two places is because many stock ETFs are diversified across Sectors including Commodities and Energy, so I have Sectors for this.  Other Individual Stocks or specialty ETFs are exclusively Commodities, so they go into Commodities Producer Stocks or Commodities ETFs.

Both Foreign and Domestic Stocks are classified as either Large Cap or Small Cap.  After you have allocated a portion of your portfolio to Domestic/Foreign, Goal/Market, Sector and Capitalization, you can put that money into either Individual Stocks, Mutual Funds or ETFs.  For Domestic Stocks, I also consider Options.

The diagram shows a similar treatment for classifying the other investment types.

I have a separate major asset type for Gold & Silver.  In a previous post I explained why I don’t consider Gold to be a Commodity; it should be thought of as the Universal Foreign Currency.  However, I only put fiat (paper money) foreign currencies into their own major asset type — Currencies.

Gold could be a major type all by itself, and Silver could be under Commodities, but Gold and Silver are enough alike and track together well enough to lump them together.

Why Bother?

So, why do I bother with this taxonomy of assets?  Two reasons:  1) If you already have an investment portfolio, you can see what percentage of it fits into each box.  This will reveal holes in your coverage which you can decide to ignore or fix.  2) If you are planning a portfolio from the top down, you can allocate percentages to each box according to your individual needs, goals and philosophies.

Although I am not as rigorous as the diagram might indicate, I do try to keep track of the percentage of my portfolio I have allocated to each box.  If I think I’m too heavy or too light in a category, I will fix it.

For many investors, this level of analysis will be overkill.  There are so many category possibilities that you may not have enough money to allocate to all, or even most, categories.  That’s perfectly OK.  In fact, even if you do have enough assets, you may choose to put nothing into one or more categories.  For example, contrary to conventional wisdom, I have almost nothing in Bonds of any type.  I have very little in the Currencies box or the Other box.  When I was an entrepreneur, all my assets were in the Other box.

How Much Should Be Allocated to Each Box?

This is the fundamental question, and, unfortunately, one answer does not apply to everyone.  In fact, even if every investor agreed with my taxonomy and had lots of money to invest, each investor would probably have a different allocation.

For example, let’s look at a traditional (old-fashioned) allocation strategy.  The following is copied from a Schwab newsletter I recently received.  They gave an example of three different portfolios:

Conservative Moderate Aggressive
15% Large Cap 35% Large Cap 50% Large Cap
0% Small Cap 10% Small Cap 20% Small Cap
5% Foreign Stocks 15% Foreign Stocks 25% Foreign Stocks
50% Fixed Income 35% Fixed Income 0% Fixed Income
30% Cash 5% Cash 5% Cash

Large Cap and Small Cap both refer to US Stocks.  Fixed Income usually means Bonds.  For Foreign Stocks, Schwab recommends for all three portfolios:  65% Foreign Large Cap, 15% Foreign Small Cap and 20% Emerging Markets.

As you can see, this is a much simpler diversification strategy than I have for myself.  It is easier to explain and (more importantly) to sell.  I can see the logic in their strategy, and I suspect that most investors are not even this diversified.  At my age, they would recommend that I have the Conservative portfolio, which I most certainly do not have.

Their portfolios completely ignore Gold & Silver, Commodities, Real Estate and Currencies.  I can understand this because the only Real Estate most people have is their home; Currencies are difficult to trade; and Gold is for paranoid nut jobs (Just kidding. I’m putting words into Charles Schwab’s mouth).  But even in Schwab’s simplified model, it takes three portfolios to meet everyone’s needs.

If I go into too much detail on how to allocate investment assets, I might cross the line into giving investment advice, which I am not qualified to do.  That being said, I think when it comes to stocks, I like to have between 60/40 and 40/60 allocated to Domestic/Foreign.  The same could be said for Developed/Emerging in the Foreign Stock category.

When it comes to Gold, even Jim Cramer recommends 10% to 20% of your assets in Gold, and I agree with him.

When it comes to Real Estate, I don’t include my home in my portfolio.  I realize that for many people, their home is their largest investment, but I choose to put as little money into my home as I comfortably can.  In fact, a case can be made for renting, but that could be the subject of another blog posting.  I do think that some of your assets should be in Real Estate, even if it’s your home.

I am also a fan of Commodities, especially Agricultural Commodities.  We are entering into a period of global food shortages, and I think this is a good investment category.

When it comes to Currencies, most people should probably not put too much money into this category.

Cash is probably the most important category, because it is the first box a beginning investor should fill.  If you don’t have enough Cash saved to cover at least four months of bare-bones expenses, you probably shouldn’t have any other investments.

I think I’ve rambled on long enough on this subject.  Maybe later I’ll have a few thoughts on some other aspects of my diagram.

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Sunday, March 6th, 2011 Gold, Stocks 1 Comment

Why I’m Not Selling Everything and Buying Gold

Lately, I’ve been reading and studying quite a bit about the problem of our national debt.  The growth of this debt is gaining speed like a runaway train, and the interest payments are projected to become an onerous part of future budgets.  All solutions to slowing this runaway train require measures of sacrifice that the US population is unlikely to accept.

We have all been riding the train for so long, that we can’t bear to leave the dining car even though we believe that at the end of the tracks is a cliff over a vast crevasse.  There are still miles of track ahead of us, and this party isn’t over yet.

We read about personal analogies to this national debt.  Families have gone too heavily into debt and have seen all equity vanish in their major investment, their home.  These families have lost their homes, and prospects for a prosperous future have vanished.  Many Americans are able to see how this applies to their own lives, and they are trying to reduce their debts and live within their means.  “Living within your means” was a popular philosophy during most of the Twentieth Century, but fell into disrespect as an outdated and unsophisticated financial strategy.

The logical conclusion to this runaway debt is the crash of the US Dollar.  The only logical outcomes are either 1) Default on the debt or 2) Devaluation of the Dollar.  Either outcome will result in the Dollar losing much of its value and purchasing power.  Pundits have given many examples of this happening to countries in the past.

I have read the logical arguments proving this inevitable result, and I honestly don’t have any logical counter-arguments.  I am regarded as a very logical person, so why don’t I just sell everything and buy gold?

According to most of these logical arguments, the only sure-fire way to preserve my wealth is to convert it all to gold.  History has proven that gold holds its value during times of inflation and the collapse of currencies.  When the currency collapsed in countries in the past, people who had gold survived financially.  So, why don’t I just sell everything and buy gold?

Something has been nagging at my brain as I read these essays of doom.  It’s not that I don’t believe them; I do, and I have blogged about these problems and probably will again in the future.  The trouble is, I don’t believe them “with all my heart.”  Although my logical mind is convinced, I have a nagging doubt – a lapse of faith in the science of economics.

I can hear your response right now, “You are just in denial.”  That may be true, but I am not denying the facts.  I absolutely agree that too much debt is very bad.  Paying off the debt will be bad, and defaulting on it will be bad.  There’s no denying that.

Well then, you say, “You are just paralyzed.  You are so terrified of the inevitable collapse of the Dollar, that you can’t take any appropriate action.”  That’s not entirely true either.  I have a significant percentage of my net worth in gold, but it’s nowhere near “everything.”  So, why don’t I just sell everything and buy gold?

Maybe its because I’ve heard this story before.  I remember Howard Ruff and other gold bugs in the late ‘70’s and early ‘80’s saying much the same thing.  They predicted doom and its been over thirty years.  Surely they didn’t think it would take this long for us to go to Hell in a handbasket.

Also, I am acutely aware that I don’t know everything.  Too many times I have been certain about something only to have something else unexpectedly happen.  And since I am smarter than the average bear, I must conclude that nobody else knows everything, either.  Other pundits may not admit to ever having been wrong, but I am skeptical.

I took a lot of philosophy classes in college, but I have to admit that it took a recent blog posting to remind me of Hume’s problem with inductive reasoning.  You see, all these arguments of doom and gloom rely on the assertion that “This has always happened in the past, so it will happen in the future.”  This is inductive reasoning.  Inductive reasoning draws upon past experience to predict future experience.  One famous example of this is:

All of the swans we have seen are white.  Therefore (“ergo” for you philosophers),
All swans are white.

As Hume points out, it only takes one counter-example, a black swan for instance, to invalidate the theory.  Hume concludes that, no matter how many repetitions there may be, we are not justified in extrapolating things we have experienced to things we have not experienced.  He further concludes that we are not even justified in arguing the probability of things we have not experienced based upon past experience.

On the other hand, George Santayana said, “Those who cannot remember the past are condemned to repeat it.” I have a counter-assertion, “Those who rely on the past are condemned to repeat it.

Let me repeat, I do not see any painless way out of our national debt problem.  It’s just that I am not so convinced that I am willing to go “all in” and sell everything to buy gold.

This blog post is not intended to make you, or me, comfortable with our national debt.  It’s not even intended to be a rationalization for investing in the same old things we have always invested in.  This is just an introspective look into why, counter to logic and reason, I don’t just sell everything and buy gold.

How about that, a blog post with no charts or graphs.

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Sunday, February 20th, 2011 Currencies, Gold 1 Comment

Worldwide Demand For Gold

Below is a chart I got from  It shows the demand for gold for the past three years.  It also shows the breakdown on what the gold is used for.

Worldwide Gold Demand

By weight, demand dipped in 2009 and in 2010 returned to the 2008 level.  However, when measured in dollars, demand grew slightly in 2009 and jumped substantially in 2010.

If you are interested in a little more detail, click on the link above.

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Thursday, February 17th, 2011 Gold Comments Off on Worldwide Demand For Gold

Gold isn’t a Commodity; Gold is the Universal Foreign Currency

Until recently, Gold was always classified as a commodity.  It is traded on the commodities exchanges using futures contracts.  It has “spot” prices like wheat and pork bellies, but Gold isn’t really a commodity.

Commodities get consumed:  Wheat gets eaten, corn gets fed to cattle which get eaten.  Oil gets burned.  Even silver is partially consumed because it is not yet so valuable that every ounce gets recycled.

Gold, however, is never consumed.  It has always been so valuable that except for minute amounts used in electronics, it is recycled.  Not much Gold has been lost in the trash.

Commodities can be hoarded.  If a speculator starts storing large quantities of coffee, sugar or wheat, thereby keeping them off the market, he is said to be hoarding these commodities.  If an exchange-traded fund buys and stores lots of Gold, they are investing, not hoarding.  Gold is not a basic requirement for life like food or energy.

Gold is really a currency, but not just any kind of currency – Gold is a “foreign currency.”  Unlike other currencies, it is foreign in every country.  In the USA, the euro is a foreign currency, but in France, it is money.  In England, the yen is a foreign currency, but in Japan it is money. Gold isn’t money in any country.  Gold is a foreign currency everywhere.  Gold is “the Universal Foreign Currency.”

What makes Gold a currency?  Before the Twentieth Century, Gold was a “real currency” or at least an “alternative currency” in many countries.  Money (coin) was actually made out of Gold (and silver).  Gold was money until all major countries adopted paper money that is not officially exchangeable for Gold.  This paper money is derogatorily called “fiat currency,” but it has, nevertheless, displaced Gold as money.

This heritage of Gold having been money is one quality that has led to its status as a currency.  Another quality is Gold’s heritage as being a store of value.  Many people consider Gold to be a better store of value than money – no matter which currency you call money.

By being a universal foreign currency, Gold can be valued in any “real currency” and “real currencies” can be valued in Gold.  Since Gold is a universal foreign currency, it can be a hedge against all currencies.  Gold can rise (or fall) in value as measured in any “real currency.”  Buying Gold using your native currency hedges against a fall in value of your currency without depending on any other currency to do better than your own.

We’ve heard of people buying Swiss Francs because the Swiss money often retains its value when other currencies fall.  But in these modern times, we can’t even depend upon the Swiss Franc to hold its value.

Like any other currency, Gold can’t be depended upon to always rise in value against the dollar (or any other specific currency).  But at least the value of Gold is harder to manipulate by governments.  Gold is a foreign currency everywhere, so no country can control it.  If a government sells some of its Gold reserves, the price of Gold will probably go down temporarily, but governments sell Gold to raise cash, not to try to drive down the price of Gold.  Governments also buy Gold when they have surplus cash, and this can temporarily drive up the price of Gold.

Today, the USA complains that China is manipulating the value of its currency (the renminbi or yuan), keeping it undervalued to give their exporters an edge against other countries.  Other countries assert that the USA is manipulating the value of its currency by “quantitative easing” which puts inflationary pressure on the dollar.  As countries race to devalue their currencies against all others, Gold stands out as a reference of value to all the currencies.  When investors flee any currency, Gold benefits.  Gold is a universal measure of wealth and a store of value.

Although the US Dollar is the world’s “reserve currency,” I think a case can be made that Gold is the world’s “reference currency.”

Gold isn’t a commodity – you can’t eat it or burn it for energy.  Gold doesn’t get used up and it doesn’t decay or rot.  In a previous post I discussed why Gold isn’t money, but it is a currency.  So don’t think of gold as a commodity, think of it as the universal foreign currency.

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Thursday, December 2nd, 2010 Gold 1 Comment

Smackdown: Stocks vs. Gold vs. Housing

In a previous post, we examined the performance of single-family Home values relative to Stocks and various Commodities.  What about a direct comparison of the investment performance of Stocks, Gold and Housing?

The chart below examines the performance of these investments over the last twenty years.  The Stocks (S&P 500) graph does not include reinvesting dividends.  The red line plots Stocks (the S&P 500 index).  The pink line plots residential Housing (the Case-Schiller index).  The gold line plots Gold, and the black line plots a “Balanced Portfolio” consisting of one-third each of Stocks, Gold and single-family Housing.  If I had included reinvesting dividends, Stocks would have performed better.
Investment Performance
As you can see, both Stocks and Gold would have increased about 350%.  Housing would have increased about 200%.  The Balanced Portfolio did pretty well (at 300%) and was less volatile.

Here is the same data adjusted for inflation (using the CPI):
Investment Performance Adjusted For Inflation
I chose the last twenty years because this is about as long as many people hold investments before retirement.  These charts assume that you invested a lump sum of money in 1990.  The performance of an investment really does depend upon when you invest your money.  That’s why financial planners recommend that you invest monthly to “dollar cost average” the money you invest.

What if you had a time machine and could go back in time to invest a lump sum of money?  What would you invest in?  Which investment is best depends upon how far back in time you travel.  The chart below shows the best investment depending upon which year you invested your money.
Lump Sum Investment Required in Specific Year
This chart shows how much money you would have had to invest in order to have $100,000 in 2010.  If you only traveled back to 2006, you would have had to invest more than $100K in Housing or Stocks to have $100K today.  You need to travel back in time to a year where the graph dips lower so that less money is required for investment.  The lower a line dips, the better the time to invest.

If you traveled back to 1990, you could have put your money in either Stocks or Gold (a little under $30K ) to grow to $100K in 2010.  The first chart also shows this equivalence.

In 1999, you wouldn’t want to invest in Stocks, because that was a peak in the market and you would need to invest $125K to end up with only $100K.  1997 to 2003 would have been a great time to invest in Gold.

At no time was single-family Housing the best place to invest (the lowest line).  In fact, there were only twelve years that Housing wasn’t the worst place to invest.  Remember, this is a “buy low” chart; it tells you when you can buy lowest.

The Case-Schiller home price index averages twenty large cities.  There are certainly some cities where home prices have performed better.  There are also some stocks that have performed better than the S&P 500 index.

Just because the house you live in has under-performed as an investment, doesn’t mean that all real estate is a bad investment.  Many people have had good success investing in income-producing property such as apartment buildings, office buildings, etc.  Income producing property has a more rational valuation method than does single-family housing.  Just as the value of stocks is roughly based on the earnings of the stock’s company, income-producing property is roughly valued on the annual rent it produces.  There is a “price-to-earnings ratio” for stocks and a “gross rent multiplier” for income property.  Buying income property is a business decision, buying the house you live in is usually an emotional decision.

So what is the bottom line of the previous charts?  I think one conclusion is “You shouldn’t have most of your assets tied up in the house you live in.”  Also worth noting is that for the last nineteen years, Gold has been the best investment.  For ten of those nineteen years, Stocks were the worst place to invest a lump sum.

The Balanced Portfolio is one-third each Stocks, Gold and Housing.  Some financial advisors suggest that you have ten percent of your portfolio in Gold.  Is ten percent enough to diversify a portfolio?

Let’s see how four different diversified portfolios performed over the last twenty years.  The chart below shows our Balanced Portfolio in black.  A portfolio with only ten percent Gold and forty-five percent each Stocks and Housing is shown in gold.  A portfolio with ten percent Stocks and forty-five percent each in Gold and Housing is shown in red.  And a portfolio with ten percent Housing and forty-five percent each in Gold and Stocks is shown in pink.
Four Diversified Portfolios
It’s obvious that the worst performance is the portfolio that only has only ten percent in Stocks, the red line.

The portfolio that is only ten percent Gold performs best until 2008 when both Stocks and Housing are in decline and Gold starts to take off.

The portfolio that is only ten percent Housing performs second best until 2009 when it takes off and is the best performer.

This chart indicates that the most important part of your portfolio is Stocks.  If at least one-third of your portfolio is in Stocks, you would have done OK.  The two portfolios that had forty-five percent in Stocks (gold and pink lines) generally did the best.

So what kinds of stocks are best?  And what about bonds?  Maybe we will discuss those topics in another post.

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Friday, November 19th, 2010 Gold, Real Estate, Stocks 1 Comment

Why Gold Isn’t Money

Although I am a big believer in the prudence of owning gold, I’m tired of hearing gold bugs claim that gold is the only real money.  It truth, gold isn’t money at all.

The gold bugs claim that the dollar is “fiat money” – that is, the dollar is proclaimed to be money without any basis in fact.  Well just what do they think money is?

The Merriam-Webster dictionary defines “money” as “something generally accepted as a medium of exchange, a measure of value or a means of payment.”

In the USA, gold is none of these things.  Most importantly, it is not generally accepted as a medium of exchange or a means of payment.  You can’t go to the grocery store and pay for your food with gold.  You can’t fill up your car’s tank with gasoline and pay for it with gold.  You can’t pay your electric bill with gold.  Gold is nothing like money.  You might just as well carry around molybdenum in your pocket.  If you have gold and need food, you have to convert your gold into dollars to buy food.  Dollars are money.

Neither is gold a measure of value.  In the USA, everything is valued in dollars; even gold is valued in dollars.  When you ask someone what their home is worth, nobody replies “185 ounces of gold.”

Now, gold IS a store of value.  This is the area where it is validly likened to the dollar.  When someone is accused of being so afraid of losing their wealth that they “put their money under the mattress” or “bury their money in the back yard,” they are referring to dollars as a store of value.  By hiding his dollars under the mattress or burying them, the fearful investor thinks he is preserving the value of his wealth.

Just because dollars are real money and gold is not real money, doesn’t mean that preserving dollars preserves your wealth.  The purchasing power of dollars, as well as the value of gold, goes up and down.  Dollars may not be a good store of value.

Gold bugs deride “fiat money” because it isn’t backed by anything of intrinsic value.  Because of this lack of intrinsic value, dollars may not be a good store of wealth and the gold bugs may be right.  You can make a case for gold being a much better store of value than the dollar.  I will have more to say about this in future posts.  As long as gold is convertible into money (e.g. into dollars), gold can be a good store of value.

Although gold is a good store of value and a good investment, gold isn’t money.

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Friday, October 22nd, 2010 Currencies, Gold 2 Comments

All the Gold Ever Mined

If you stacked all the gold ever mined throughout history on an NFL football field, goal to goal and sideline to sideline, the stack would only be two yards high.

But it would weigh over 360 million pounds.

And it would be worth about $6.9 trillion (at $1,300 per troy ounce).  That’s about 5.3 billion troy ounces.

If the USA backed its money with gold, the price of gold would have to be $8,250 per ounce.

This shadow price is derived from the “Bretton Woods formula for valuing money  in a gold-exchange regime (i.e., the fixed value of a currency equals its monetary base divided by official gold holdings).  Under this formula the exchange rate of the U.S. dollar to an ounce of gold would be about $8,250 presently, a figure that reflects the amount of monetary base inflation already engineered by the Fed.  (The U.S. monetary base approximated $2.15 trillion in September, 2010 and reported official U.S. gold holdings have remained relatively constant at about 8,133.5 metric tons or about 261.5 million ounces.

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Saturday, October 9th, 2010 Gold 1 Comment

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I am not a registered financial advisor. I only offer opinions, and sometimes these opinions veer off at weird angles from conventional wisdom (That's probably why you are here). My advice is, "Don't take my advice." Read my sidelong glances at economic issues and form your own conclusions.

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