Friday, December 17, 2010

Developing an Asset Allocation Model (Part II)

In the first part of the series we discussed the need to understand your risk tolerance before developing an asset allocation strategy. In this post we’ll talk a bit about assets classes you might consider.

I think of the world as made up of four general categories of assets: Cash equivalents, Bonds, Stocks and Other.

Cash Equivalents

For our purposes, cash equivalents consist of assets that you can readily turn into cash without suffering asset price volatility or a significant cost for the conversion. Stuffing your mattress with currency is one way to hold your cash. Most people choose to use checking accounts, savings accounts and money market funds that pay a modicum of interest. Treat Certificates of Deposit (CDs) as a cash equivalent if there is no penalty for cashing them in early. If the penalty is as much as one month’s interest, I would still consider it as a cash equivalent. But if you can’t cash it in before maturity and are required to sell it to a third party or if there is a sizeable penalty for cashing in the CD, then I would consider it a bond.


We’ll consider any loan not counted as a cash equivalent as a bond. The loanee can be a corporation (corporate bond), a state or local government (municipal bond), the US Government (Treasury bills and bonds), foreign corporations or governments, or a loan to Junior that you really do expect him to repay.

Some bonds come with periodic interest payments; others are sold at a discount from the maturity value and you collect earnings when the bond matures.

Some bonds are secured by assets. (For example, when you take out a car loan, the loan—a bond from the bank’s perspective using our definition—is backed by your car. If you don’t make the payment, the bank takes your car.) Some bonds are backed by plant and equipment, others by tolls paid on a highway. Other bonds are backed only by the full faith and credit of the organization.

For reasons I’ll explore in a later piece, I include pensions due me as bonds. I am lucky enough to have a corporate pension from one of my former jobs. Most of us have Social Security. Both have characteristics that make them bond-like.


I would substitute the word equities for stocks because that’s how I think of the category. An equity position means you are eligible to share in the profits of the company while it is an ongoing concern and share in its liquidation value if it stops doing business. (The liquidation value is often zero because bond holders have to be paid off before the equity holders.) Partnership shares in a business would fit here.


Real Estate is included under “other” as are precious metals, commodities, art, the baseball card collection your mother didn’t throw away and anything else that has value.

I can see the purists out there pulling out their micrometers to measure the fit of some asset or another with its assigned bucket. “What about convertible bonds?” (bonds issued by corporations that can be converted to common stock under certain conditions), they say. If most of a convertible bond’s value is attributable to its coupon payments and principal return, call it a bond. If most of its value relates to the fact you can convert it into an equity position in the company, treat it as a stock. When in doubt choose those characteristics that most determine its price.

Could you have more classes? Of course. In the next two posts we’ll consider subclasses and discuss which ones are worth separate recognition.

Next up: Asset Subclasses in Your Portfolio

~ Jim

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