My Personal Finance Journey

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Reengineering My Portfolio Management, Part III: Asset Allocation - The Investable Asset Classes

Contributed by mm | February 17, 2007 4:05 PM PST

WHAT DOES ASSET ALLOCATION MEAN TO ME?

My earlier pursuit of CFA certification did teach me a lot about asset allocation. In short, I believe in the two principles of asset allocation:

- Each asset class brings unique return and risk patterns.
- By properly mix different asset classes, one can reduce risks (defined as volatility of portfolio) while maintaining an acceptable return level.

(On the flip side, I don't believe that quantitative models can determine the optimal asset allocation for each portfolio -- that may happen in textbooks but certainly not in real life. My reasoning? Considering the globalization and acceleration of financial innovations, historic return and risk patterns of each class may not be indicative of the future at all, so no one will have a perfect crystal ball about the return and risk patterns of asset classes into the future, not to mention how to best mingle them toward a "perfect" portfolio.)

INVESTABLE ASSET CLASSES

The single most important lesson I learned from my seven years of investment experience is to recognize what I don't know. Surely there are many financial publications advocating everyone should have some exposure in precious metals, commodity, or any exotic investment tools that just had a banner year, but I don't think I will be able to seriously understand and appreciate the value of such diversification. Therefore, I'll keep it simple by just focusing my portfolio on four asset classes:

- Domestic Equity: Stocks of publicly traded companies in the U.S of all capitalization.
- Foreign Equity: Stocks of publicly traded companies outside of the U.S of all capitalization.
- Cash & Fixed Income:
* Cash: Cash and highly liquid money market accounts, either in or outside of the U.S.
* Fixed Income: Bonds, CDs, or other financial instruments with fixed income nature, either in or outside of the U.S.
- MSFT Stock Option: Vested employee stock option grants from my employer.

Notes:

- The above definition does not mean I have to invest in individual stocks or bonds; I can still have indirect exposure by investing in mutual funds or ETFs that invest in such asset classes.

- While cash and fixed income are usually classified as two different asset classes, given the slightly inverted yield curve, and uncertainty surrounding Fed's next move, I see cash to perform as well as fixed income with much less risk and better liquidity. Plus, some of my CD holdings are essentially risk-free cash plays since I do intend to hold them to maturity. Therefore, I choose not to cut an arbitrary line between the two. Also, for Cash & Fixed Income, most likely my only international exposure will be to invest in some cash & fixed income vehicles denominated in Chinese Yuan. (Again, I don't and won't have intimate knowledge about those in other currencies.)

- I have to consider MSFT Stock Option as a unique asset class since 1) currently almost 10% of my portfolio is held in this class, 2) all options will only expire after 2011, so I'm not in a hurry to dispose them -- I will have a lot of time to study how I should unwind these positions, which also means I have to live with it and its inherent volatility in the near future.

Next: The Asset Allocation In Percentages

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