By Vern C. Hayden, CFP, President of Hayden Financial Group

Asset allocation is based on the incontrovertible truth that a portfolio needs to be structured on the basis that no one can predict the future. A colleague of mine predicted that the S&P 500 would be up about 17% in 2007. He is now rationalizing his inaccuracy by blaming the sub-prime mess. "If it hadn't been for that, I probably would have been right."

Another example: back on January 6, 2003, Barron's published an article showing the predictions of the 22 experts appearing on Louis Rukeyser's "Wall Street Week" on the performance of the Dow and the NASDAQ for 2000 & 2001. The "expert" predictions didn't even come close to the actual results.

So, if no one knows the future, then how do you go about structuring an investment portfolio?

Asset Allocation Strategy Utilizing Mutual Funds

To begin with, investors should decide on a strategy for allocating their assets. My choice is to use mutual funds. This way we can identify the best manager for any particular category. Do not use index funds. Index funds are glorified traps in down markets. They are not actively managed, so no one is there to save the investor in down markets. There is an active manager that is superior to any index fund.

Keep in mind, before Socrates drank the poison he taught everyone how important it is to "Know Thyself." Investors must examine themselves for three important issues. First, what are the goals? Is it to buy new businesses? To contribute to charities? To fund a very comfortable retirement? Second, how much time does the investor have to accomplish those goals?

Finally how much risk can the investor take in accomplishing his goals? For instance, investors probably shouldn't invest in a stock mutual fund if they don't have three years or less to reach a goal. If the investment loses money the investor may not have enough time to recover.

Of all the criteria, risk is by far the hardest thing to figure out. While the market is going up I've heard people say they could lose 20% before they would worry. Those same people started to panic if their portfolio was down 10%. The amount of risk anyone can take tends to vary with market conditions, age and life experiences. It is usually safest to start with a portfolio that is more conservative than aggressive.

Structuring the Portfolio

The investor's portfolio should be structured with an asset allocation consistent with his benchmark. There are five basic asset classes that I recommend; stocks, bonds, cash, real estate and commodities. Set the allocation by choosing what percentage to allocate to each of the asset classes. Investors may choose to change the allocation at times, but try to have a good reason for doing it, so short term reactions don't destroy the long term strategy. Don't try to time the markets, because it doesn't work over an extended period of time.

Think of the portfolio as though it was a sports team. Investors need an offense and defense. The defense will help protect portfolios in down markets and the offense will help it grow in up markets. Here are some examples of offensive funds:

  • CGM Focus

  • Delafield

  • Fairholme

  • Growth Fund of America

  • Thornburg Value

  • Wintergreen

Here are examples of defensive funds:

  • Hussman Strategic Growth

  • Harbor Bond

  • FPA New Income

  • Loomis Sayles Bond

  • FPA Crescent

Here are some International/Foreign funds:

  • Dodge & Cox International

  • Europacific

  • Longleaf International

  • Matthews Pacific Tiger

Here are examples of the "heart" of a portfolio. Think of the previous funds as the soul of a portfolio, but these are examples of core hybrid funds. These funds make up about 40% of our portfolios:

  • Capital Income Builder

  • Black Rock Global Allocation

  • Ivy Asset Strategy

  • Oakmark Equity and Income

  • Pearl Total Return

  • Vanguard Wellington

  • Thornburg Investment Income Builder

The heart of a portfolio consists of managers that can invest in any asset class. They can also be in foreign investments.

Allocation Changes with the Managers

My portfolios are vastly different from most of those my colleagues have designed. The reason is that my asset allocation changes with the managers. I don't know what it is exactly at any given time because the very heart of my portfolio, usually about 40%, consists of managers that can virtually go anywhere at anytime. I can't possibly track where they are all the time. I don't need to know. These funds can play offense and defense anytime they want. The reason they are the heart of the portfolio is because they help supply the life blood that helps stabilize the portfolio. It helps control risk.

The main criteria I use in choosing these kinds of funds are the managers' philosophy of investing and their track record in both up and down markets. I like to see a value bias that has helped create a stable performance record. For instance, the S&P 500 was down about 45% from 2000 through 2002. The NASDAQ was down 85% during the same period. All of the hybrid funds I've listed were up over the three year period. The worst one year loss was 11%. Pearl Total Return had its first full year in 2002 and was down 11%. Thornburg Investment Income Builder started in 2003, so it had no record during the bear market.

Here is a sample portfolio, but I am not suggesting this is a portfolio for any investor. We do make changes, so this portfolio could look different a year from now. Use it at your own risk. Here is one way to allocate 5 million dollars:

The Soul of the Portfolio

OFFENSE

Wintergreen

500,000

Fairholme

500,000

Thornburg Value

250,000

Sub Total:

1,250,000

DEFENSE

Hussman Strategic Growth

250,000

FPA New Income

500,000

Harbor Bond

500,000

Sub Total:

1,250,000

INTERNATIONAL/FOREIGN

Dodge & Cox International

350,000

Matthews Pacific Tiger

150,000

Sub Total:

500,000

The Heart of the Portfolio: HYBRIDS

Capital Income Builder

500,000

Ivy Asset Strategy

500,000

Thornburg Investment Income Builder

500,000

Vanguard Wellington

500,000

Sub Total:

2,000,000

TOTAL:

5,000,000

Investment advisors that believe they must control the precise allocation of a portfolio would never use this kind of strategy. By getting outside the confines of academic structures and thinking more independently it enables us to pursue a more productive strategy for investors. We do not get preoccupied with how much of a portfolio is in cash, stocks, bonds, real estate or commodities. Instead we position the managers to complement each other. In a sense we allocate managers. If nothing else this discussion should encourage investors to do their homework or hire a professional.