The psychological need of the investor is a major contributor to the dominant asset allocation chosen.
This is a preliminary, hopefully useful insight in a world of over-simplification. Further it can be a useful aid in structuring timespan portfolios.
For the moment think of an asset allocation spreadsheet with three psychological columns and four timespans.
The psychological aspects are income, value and growth, while the timespans are: Operations Portfolio for Now; Replenishment Portfolio for the Intermediate Term; Endowment Portfolio for the Long-Term; and, Legacy Portfolio for the longest term.
The oldest investment need is to meet critical expenses. For each investor these may go from the immediate need to put food on the table to obtaining the most expensive item of fashion which can be real estate, life style, breakthrough medical care or the latest gadget.
The income need includes the cash generation from capital and capital itself. Enough income is in the end not a statistic but a feeling of wellbeing.
The need for income may be immediate and/or a stream of cash for different timespans. For example, it may be high immediate expenses or future streams of payments requiring well covered cash generations. To the extent of long-term payments in a world of paper or electronic money, the impact of inflation should be considered as to the value of cash levels.
Most income driven investors tend to live very much in the present. They view loss of income as much more serious than a missed opportunity to enhance income and capital generation. They believe that they are conservative, but often they are taking into account only what is present and not the value of current and future income.
At prevailing interest rates on presumed high quality fixed income paper, investors are being pressed to meet perceived payment needs. This is particularly true for US foundations with a tax requirement pay out of 5% over time.
Currently, in most cases income investors are ignoring the present but low level of inflation. This is reducing the real value of both the spending and capital base.
Our preferred solution is to invest in established companies that have a long history of growing well protected dividends in good times and bad. Currently there are a number of these in the financial services field which we can discuss offline.
In these cases I believe the income is secure and generally grows faster than normal inflation. The risk is in the fluctuation of the price of the shares. In many existing cases they are reasonably priced in terms of their intermediate- term outlook.
Value investors really don't like making meaningful mistakes. Perhaps earlier in the investment experience they were exposed to big mistakes made by others or themselves. Their reaction to prevent future mistakes is to accept a well-defined price discipline.
They will often quote the two big investment rules: Rule 1: Don't lose money and Rule 2: Don't forget Rule 1. This is the historic coda from my old professor David Dodd of Graham & Dodd fame. This strong survival instinct at times prevents them from buying into big opportunities with substantial risk of loss.
They are just the opposite of successful venture capital investors that have more losers than winners but the winners are large enough (and then some) to make up for their losses. Because we live in an uncertain world, most often they own lots of securities to diversify their risks.
Most of the time they are attempting to arbitrage the difference between current price and some standard of value. It is in the selection of this standard of value where the value investor tribe breaks into sub smaller units or families.
Many of these families use the various corporate accounting statements to determine their values; e.g., book value, net tangible value, revenues per share/per customer or net liquidation value.
It has been my experience that often many stocks sell at a 30% discount to their theoretical value. However, normally this discount is not fully captured quickly without some internal or external activist event.
In effect the value investor lives in the current price range and wishes for the market to relatively quickly recognize the present value. These kinds of investments, when they work well, are found in the Replenishment Portfolio which invests through the present cycle.
Because of their risk aversion value investors have better than market performance record, but often underperform when the market is looking for dramatic changes in the future.
The growth investor fundamentally believes in dramatic change that most do not fully comprehend. The change could be based on technology, radical price movements because of fundamental and largely permanent supply and demand shifts, as well as substantial and lasting impacts of demographic evolution.
The successful growth investor not only believes that he or she can spot future changes but also which company can be the most successful exploiter of these changes. Relative to the value investor they are more tolerant of near-term price risk because they see larger and longer-term price rewards.
Except for large funds investing in smaller companies they tend to have more concentrated portfolios. However, they are much more sensitive to changes on the horizon which makes them less patient than value investors. Thus often they have more concentrated higher turnover rate portfolios.
Putting income, value and growth to work
In each cell of our intellectual investment matrix of the three asset allocation types and the four timespan investment periods, the investor should determine the appropriate mix.
Thus one might have 60% in income, 30% in value and 10% in growth for the Operational Portfolio; 60% in value and 40% in growth for the Replenishment Portfolio and the reverse in the Endowment Portfolio.
The Legacy Portfolio could have 70% in growth and 30% in value. Please note that I do not divide the world into domestic and international. I believe just about every company and most individuals are increasingly impacted by activities beyond their national borders.
As indicated in earlier blogs "We are all Global." The location of incorporation or main securities market is a third level sort for administrators and sales people to worry about.
The very next trading day changes the actual allocation from the planned and prior day. Far too many investment organizations rebalance mathematically back to an original allocation.
I believe rebalancing is an account-specific responsibility. I am very conscious that most large successful investors/entrepreneurs have made most of their money in a few or even one security.
I am also aware that a family's concentrated wealth can be wiped out in a major failure. Thus, I suggest that rebalancing is a critical decision for the capital owner to make. One can see the degree of concentration will change as investment control shifts from the founder to succeeding generations of family workers and non-workers.
Further, to me rebalancing is essentially a market call of quasi permanent market change or a return to some concept of "normal." The decision may be heavily influenced on payout considerations from how "income" and capital are defined.
What not to invest in the legacy portfolio
The whole concept of the Legacy Portfolio is that since the current generation of investment managers are responsible there are likely to be future periods of disruptive change compared to the present construct of our investment thinking.
Often we may want to focus on investments that would benefit from expected changes. It is equally important to focus on what should not be there.
Two possibly negative trends that should be considered for reduction or elimination in a Legacy Portfolio are:
1. JPMorgan Chase
I have great respect for JPMorgan Chase and its CEO Jamie Dimon. Personally I have owned the stock for many years and it is our main deposit bank. Nevertheless, it should not be considered in a Legacy Portfolio of companies to benefit from disruptions.
I commend Dimon’s brilliant 46 page letter to shareholders that describes their success and outlook. It is the bank’s very success under Jamie that makes me question whether at some future point the stock of JPMorgan Chase may not be an investment leader.
If one links the performance of JPMorgan Chase from the date of its merger with Bank One its stock was up 211% compared with a gain for the S&P500 of 154.8% and the S&P Financials 32.3%. For the last ten years the annual compounded growth was +8.6%, vs. +6.9% for the S&P and -0.4% for the financials.
JP Morgan Chase has been a great stock. In the same period the large foreign banks have retreated. My fundamental concern is that it is less likely that the bank's relative performance advantage will continue. I expect that at some point the global financial businesses will be restructured to reduce the odds of continued success for the current bank.
2. Urban real estate
The second area to possibly exclude in the Legacy Portfolio is urban real estate. Cities are absorbing rural populations all over the world for sound economic and demographic reasons. At some point there will be intolerable overcrowding and with the advent of the internet and driverless vehicles, some of the people and capital will migrate to exurbia.
Whether these two thoughts work out, the key message is to look for those investments that will be advantaged and disadvantaged in the future.
Michael Lipper is a former president of the New York Society for Security Analysts, he was president of Lipper Analytical Services Inc. the home of the global array of Lipper indices, averages and performance analyses for mutual funds. His blog can be found here.