Unless you are totally confident that you have discovered a way to
achieve high returns with minimal risks, the prudent course of action is
to diversify your investments. If you know when the market will go up and
when it will go down, you should probably quit your job and devote all
of your time and money to take advantage of your unique insight. Speaking
for myself, I don't know how to tell when any investment is going to hit
a high or a low point. Nor am I able to divine which type of investment
is going to do well in any time period. But I do know that different kinds
of investments tend to have an offsetting effect. When stocks are doing
very well, bonds are usually out of favor, as are hard assets such as gold.
When interest rates are rising neither bonds nor stocks are likely to do
well. Real estate doesn't follow the same "rules" as stock or bonds. Over
time, different kinds of investments tend to have an offsetting effect
if you have your savings allocated among different categories.
But how should you allocate your savings between different kinds of
assets? The essence of one diversification theory involves four “rules”.
The first is that you should not put more than 5% of your investment
assets into any single security, partnership or fund.
The second is that you should not put more than 10% of your investment
assets into any single organization. This means that you would not use
a family of mutual funds for total asset allocation. It also means you
would not put more than 10% of your assets into a single variable annuity
contract, even if you have investment discretion over the selection of
funds. The 10% is presumed to be the most that would be willing to lose
at any one time. For some people that might be 25% or even 33%.
The third diversification rule is that you should allocate your investments
into a minimum of four of seven different categories. That would require
you to have no more than 25% of your assets in any single investment category.
The fourth rule is that your allocations should be based on all of your
varied investment funds - not just the ones that you manage yourself. This
means you would include your vested pension assets, charitable trusts,
variable life or annuity policies and even your business assets or offshore
trusts in your total allocation analysis.
Briefly, the seven groups of assets include (1) cash, (2) debt instruments,
(3) equities, (4) real estate, (5) natural resources and commodities, (6)
tangibles or collectibles and (7) business interests. Please note that
foreign investments are not a separate category. You could have some foreign
investments in each of these seven groups. Where a specific investment
seems to fit into more than one category (such as a real estate limited
partnership or REIT), you would generally allocate that investment based
on the underlying assets that it holds. Some assets just don’t fit neatly
into any single category and you just have to make a reasoned judgment
on where it fits.
Some Exceptions To The Rules
For practical reasons, there are necessary exceptions to these rules.
One exception is that these rules don’t apply to any “fund” or organization
which you effectively control. If you are the general partner for a family
limited partnership, these rules would not apply to the partnership as
an investment entity. For practical reasons, you may not be able to control
how much goes into your company pension plan or how it’s invested. But
if you can control your retirement plan investments, then those assets
should be part of your total allocation analysis. When you control a business
entity during your working years, you might have nearly 100% of your assets
in that entity and those assets might not be divided into a minimum of
four asset groups.
Some Practical Implications of These
Rules
Based on these rules, you would not have more than half of your assets
exposed to the U.S. stock or bond markets, with no more than 1/4 in stocks
and an equal limit on bonds. To minimize your risk further, you might decide
to split each of those two groups into U.S. and foreign groups. That would
reduce your exposure to no more than 25% of your assets in U.S. stocks
and bonds.
The equity part of your portfolio might include some managed variable
life or annuity contracts, assets in foreign trusts in which you have do
not have total control of the trustees, or even managed commodity accounts.
That would further reduce your exposure to a “correction” in U.S. stocks.
Your fixed income/debt portfolio might include life insurance cash values
or fixed return annuities, tax exempt bonds or exempt equipment leases,
tax lien certificates, installment loans, mortgage REITs with fixed payoff
schedules and charitable annuity trusts. By the way. This system treats
managed bond accounts as equities because you are relying on someone to
make buy/sell decisions.
Your cash account doesn’t need to be non income producing. It could
include funds in checking accounts, savings accounts, short term C.D.s,
short term U.S. bonds or T-Bills.
Your real estate investment group would include your residences, any
non leveraged real estate partnerships, business related real estate or
rental property and any farm land or raw land. An REIT would go into the
debt group if it was primarily a mortgage backed security.
Natural resources and commodities include direct investments in oil
and gas, coal, water, farm crops, livestock or timber. Contracts that you
own for these assets would also be included, but managed commodity accounts
would be in the equity group. Where you have partnership interests in business
ventures relating to these kinds of assets, you would normally include
them in the business interests category rather than in this category. As
a general rule, most people don't have direct investments in this category
unless they are involved in a related kind of business.
Tangibles and collectibles include an assortment of “hard assets” such
as bullion and bullion coins, plus traditional collectibles such as rare
coins, stamps, art, antiques or precious gems. Generally, gold stocks would
be included in the equity group, but if you know that a specific gold stock
price is strongly correlated with gold prices, then you might choose to
put it into this group.
The last group is the business interests category. It would include
a controlling ownership interest in a closely held corporation or partnership,
a proprietorship, investments in most kinds of limited partnerships (or
other limited liability entities) and most kinds of equipment leasing ventures
except for triple net leases to large organizations with strong credit
ratings.
For most people, this last category is the one where they make most
of their money. Even when a specialty kind of investment activity becomes
a major avocation, it should be treated as a business venture. The essence
of a business venture is that (1) you control it, (2) it requires your
time, energy and creativity in addition to your capital, (3) there is also
a significant risk of loss, and (4) there is a substantial potential for
profit.
For those of us who make our money in other kinds of business, it’s
difficult to find enough time to really manage a growing investment portfolio
and to stay informed on a host of changing political, economic, tax and
market conditions. If we don't stay informed and don’t have the discipline
to be willing to buy when no one else wants what we are buying or to sell
when everyone else is frantically buying, then I believe our best choice
is to minimize our losses instead of trying to maximize our gains. And
I haven’t found a better way to do that than with an organized system of
asset diversification like the one described here.
Asset Allocation and Asset Protection
Entities
How do these rules apply in the context of various kinds of asset protection
planning? First of all, it provides substantial protection from severe
losses in your total portfolio.
But your other asset protection devices will affect the kinds of entities
you use and the degree of control that you have over those entities.
There is a trade off between retaining effective control over your assets
and being able to remove those assets from the claims of future creditors.
However, if you can retain control of any entity into which you have transferred
your assets (such as a limited partnership), then these diversification
rules would not apply. In the case of entities such as charitable trusts,
the extent of your ongoing control is greatly reduced and I suggest that
the allocation rules do apply to those assets.
In the context of putting your money into an offshore trust for asset
protection, if you don’t have absolute personal control over those assets,
you should not put more than 10% of your assets into the offshore trust
- unless you are prepared to lose them.. In some cases, you might be tempted
to put more than 10% of your money into an offshore structure because you
have some reason to believe you might lose it anyway.