A Canadian's random thoughts on personal finance

Oct 27, 2008

Bottom-up asset allocation

Over at Thicken My Wallet is an article on The Role of Cash in Your Portfolio. There, he gives an opinion how much cash is the right amount. It's decent advice, but it contains some numbers that seem rather arbitrary, as does all advice I've seen in this area.

My approach is different. I don't start from the top with a target percentage; I derive that percentage from my financial situation.

My allocation is based on two rules:

1. Never be forced to sell stocks. I want to sell them at a time of my choosing, when the market value is fair.

2. Strive for the highest possible return, subject to rule #1.

To handle #1, we keep our expenses down below our income, we have an emergency fund amounting to several months' expenses, and we have other savings accounts for anticipated expenses such as our next car. This puts us in a position where we'll only be selling stocks under extreme circumstances where getting the best value for our stocks will no longer be our highest priority.

Then, rule #2 amounts to investing the rest in a diversified portfolio of stocks. It also includes a small amount of bonds and cash to allow for rebalancing, since it has been shown that a portfolio with rebalancing can outperform every one of the individual assets in that portfolio. Paradoxically, adding some bonds and cash into your portfolio can help it outperform a portfolio of pure stocks over the long term.

I'm aware that maximizing returns, in theory, requires leverage. Personally, I abhor paying interest on debt, and I don't like the additional risk, so I'm not leveraged. I'll just have to live with the returns I can get from my own money in the stock market.

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