"Asset Allocation for Income Investors"

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Asset allocation goes back to the work of Harry Markowitz in the 1950s and Modern Portfolio Theory. Essentially it says that the risk of an entire portfolio is reduced when that portfolio is divided among different types of investments, because there's no positive correlation between those investments.

Asset Allocation is a Risk Management Strategy

Thus, although one investment might go down, another will go down -- and so the entire portfolio will do better in the long run, with less risk on the whole. That's the basic asset allocation model.

Of course, it's true that in the short run, an asset allocation strategy actually reduces performance by keeping capital out of the asset type which is performing best. But that cannot be foreseen.

In 1986 a research paper by Brinson, Hoad and Beebower came out. They studied the performance of 91 pension fund managers. Their analysis concluded that the active management of a pension fund actually REDUCED overall performance.

They concluded that in the long run it was better to spread an investment over stocks, bonds and cash and then rebalance them periodically using dynamic asset allocation

Many brokerages jumped on this optimal asset allocation concept and mass-marketed asset allocation recommendations in a very formulaic and inconsistent way.

Nobody Knows the Ideal Asset Allocation Mixture of Assets

Nobody has ever determined what is the optimum percentage of bonds versus stocks versus cash. That would be the ideal asset allocation, but nobody knows what it is.

Nobody has ever determined what is the optimum percentage of bonds versus stocks versus cash for particular groups of people. Typically, brokerages have customers fill out an asset allocation questionaire and then allocate assets based on how much risk customers say they can handle, putting them into asset allocation funds.

My mother's broker converted into one of these asset allocation programs. I don't know how he determined her risk profile -- she tells me that she never answered any questions about this.

Since stocks are widely known and accepted as the main way these portfolios grow, the more customer will accept risk, the more money is put into stocks.

This does increase long term growth but also increases volatility.

Also, nobody rebalances consistently

Many experts believe that rebalancing should take place once a year. Others believe that is not necessary.

And rebalancing incurs taxes on capital gains and transaction costs.

Asset Allocation does Not Require Periodic Rebalancing, in My Nonacademic Opinion

One way to avoid this is to do it all within variable annuities, which is too far off the subject to go into here.

But I've figured out that an intelligence asset allocation program for income investors saving for retirement can avoid capital gains and transaction costs.

Here's the simple explanation -- you reinvest the income you get

The more that asset type increases in market price, the less of it the income it generates can buy.

The less that asset type increases in market price, the more of it the income it generates can buy.

Let's say you buy 100 shares of The Wonderful Acme Company for $50 and reinvest all dividends.

You earn that same $60 in end of year dividends, but since you're reinvesting, it buys you more shares.

How many? That depends on where the market price has gone.

If it's still at $50, then $60 buys you 1.2 shares, so you have a total number of 101.2 shares.

Next year, your dividend is $.6 times 101.2, for a total of $60.72.

Some Assets Go Up in Price More Than Others, but Over Time This Should Even Out Automatically -- that's the Principle Behind Asset Allocation

But if the market price went up to $60, the same $60 dividend is reinvested for only 1 share, for a total of 101 shares.

If the market price went down to $40, the same $60 dividend buys you 1.5 shares, for a total of 101.5 shares.

So actually, when you're reinvesting income, it's to your ADVANTAGE to have the market price as low as possible

It doesn't make your brokerage account look good, and your friends won't want to hear you brag about your dividends bought you more company shares because the market price is so low, but it's true.

When you're reinvesting income, you're better off in the long run if the market price stays low.

This is also the main reason why slow-growing, low investor expectation stocks do better in the long run, as explained by Dr. Jeremy S. Siegel in The Future for Investors.

The Standard Oil of New Jersey investors who let their dividends ride, ultimately did much better than the cowboys who wanted the high growth IBM. Because the dividends paid by Standard Oil of New Jersey over the years bought many more shares than did those of the highly priced IBM.

If you are allocating assets, the same thing goes for all asset classes in your allocation mix

If bonds go up in price, your reinvested interest payments buy few new bonds.

If bonds go down in price, your reinvested interest payments buy more new bonds.

So if stocks are down but bonds up, your entire portfolio will automatically buy more stocks than bonds.

That's the essence of asset allocation theory. To assume that last year's low asset may be next year's high asset, and therefore to load up on it.

Instead of incurring taxes and transaction costs, let the dividends and interest do all the "rebalancing" for you.

One good thing about this rebalancing is that if done properly it would avoid the Growth Trap

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