Asset Allocation vs Diversification
Asset Allocation is the process of dividing investments among different kinds of asset classes (such as stocks, bonds, cash, real estate, commodities, etc.) to try to meet specific financial goals. Traditional asset allocation models do not work for real people because their portfolios are much different from institutional portfolios. The portfolios of most people do not have enough zeros (000,000,000).
Over 80% of all American households have a net worth that is less than $250,000 which includes the value of their home. Some of the big differences between institutional portfolios and those of most individuals include single vs. multiple goals, single vs. multiple time horizons, simple vs. complex tax treatment, professional vs. amateur investment management.
These differences led the founder of the Cambridge system to create a Functional Asset Allocation (FAA) model for individuals. FAA illustrates how individuals build wealth as measured by Net Worth.
For example, while Real Estate is recognized as a separate asset class by most money managers, the value of your personal residence is more than a financial calculation. A great deal of your home’s value is in your own enjoyment. Likewise, Functional Asset Allocation takes into account the reality that taxes are a driving force in Middle America.
While Modern Portfolio Theory seeks to optimize statistical returns on a passive, static investment portfolio relative to risk based on historical performance, Functional Asset Allocation uses a different paradigm. It is based on optimizing value in the utilization of assets in a household, and on the psychological needs and life goals of real people in a dynamic society.
Interestingly, our experience and comparative analysis have demonstrated that Functional Asset Allocation not only provides most of the diversification benefits of Modern Portfolio Theory, but also yields a better after-tax return with less risk for Middle America.
1) Functional Asset Allocation – all your assets, including your home and personal belongings.
2) Traditional (institutional) Asset Allocation – only financial assets, including checking accounts, savings, emergency funds, etc.
Using Functional Asset Allocation, your assets should be distributed across three asset categories: Interest Earning, Equities, and Real Estate
Generally, you want to have 1/3 (range of 25-40%) of your net worth in each of the three major asset classes. Each of the major asset classes serves practical functions in wealth accumulation and risk management.
The analogy of the farmer is useful for understanding the separate functions of the three major asset classes. The interest earning asset class is what the farmer puts in the root cellar to feed the family during a bad winter or reseed his fields after a drought.
The real estate asset class which is primarily your home is the equivalent of the farmer s garden. The garden provides food to eat and flowers for enjoyment. The equity asset class is the equivalent of the farmer s fields. The fields are the farmer s engine for growing wealth. The larger the fields and the more productive the crops, the faster his wealth grows.
