Excerpt from If Not Stocks What? by Gene Walden

Allocating Your Assets

Timing the investment market is a lot like going to a party. If you’re buying stocks, for instance, you don’t want to be the first one at the party, nor the last to leave. You want to get there just as some of the early guests are arriving, then stick around until a few guests are starting to move toward the door. That’s when you grab your coat and head for the next hot spot.

That would be asset allocation at its best. Unfortunately, no one is quite perceptive enough to move adeptly from party to party without some missteps. That’s why it’s important to spread your assets across a broad range of investments. Asset allocation and diversification may not lead you to the maximum possible total return, but it can help you avoid the type of portfolio meltdown many tech stock investors experienced in recent years. Asset allocation can bring you smoother, steadier, safer investment returns.

You may be able to get an edge up on the market if you can make some subtle shifts in the weighting of your portfolio to coincide with movements in the economic cycle. The economy typically goes through five different economic cycles, each with its own investment characteristics. You wouldn’t want to make all your buying and selling decisions based on the economic cycles alone, but by understanding the effect they can have on stocks and other investments, you may be able to tweak your asset allocation from time to time to improve your performance.

Here are the five phases of a typical business cycle, and the types of investments that tend to perform the best in each cycle:

1. Recession. This slow period in the economy is characterized by falling production, peaking inflation and weakened consumer confidence. Although it never seems like it at the time, recessions are usually a good time to buy cyclical stocks (such as automakers, paper companies and other heavy manufacturers). Their earnings may be flat, and their stock prices may be floundering, but they are among the first stocks to take off when the economy turns around. Long-term bonds are also a good bet in a recession because the government tends to lower interest rates to help spur the economy. As interest rates go down, bond prices go up.

2. Recovery. Hope begins to emerge. Recoveries are marked by stimulatory economic polices, falling inflation and increasing consumer confidence. They are a good time to buy stocks, long-term bonds, commodities, oil and gas, and even precious metals to hedge against a possible up-tick in inflation. Smaller emerging growth stocks may do especially well during a recovery, and cyclical stocks should still have some growth left. Real estate also does well during a recovery.

3. Early upswing. Once the recovery period passes, consumer confidence is up and the economy is gaining some momentum. The early upswing is probably the healthiest period of the cycle because economic growth can continue without any signs of overheating or sharply higher inflation. Generally speaking, consumers are prepared to borrow and spend more, and businesses—facing increased capacity use – begin investing in plant or office expansion. Unemployment falls, but inflation may pick up. Higher operating levels allow many businesses to cut unit costs and increase margins and profits. The stock market should remain strong, while commodities will continue to rise modestly. The early upswing stage could last for several years. Real estate should continue to do well, but unload the cyclical stocks, because their growth is probably over.

4. Late upswing. It’s hard to distinguish between the early upswing and the late upswing. But you need to look for subtle signs. The economic boom is in full swing. Manufacturing capacity utilization is at or near a peak. Stocks are rallying, and unemployment is falling. Real estate prices and rents move up strongly, prompting a construction boom. Inflation picks up as wages increase in the wake of labor shortages. With interest rates rising, bonds become less attractive. In fact, the overall stock market may hit a lull. But commodity prices should continue to rise, bolstered by a huge demand for raw goods to keep the manufacturing boom going.

5. Economic slowdown. Once the economy has gone through its recovery and upswing cycles, it’s time for a nap. Economic activity starts to slip. Short term interest rates move up sharply, peaking as confidence drops. The slowdown is exacerbated by the inventory correction as companies, suddenly fearing recession, try to reduce their inventory levels. Manufacturing capacity utilization begins to drop while wages continue to rise, resulting in increasing inflation. In the markets, bond yields top out and start to fall. The stock market may fall, perhaps significantly, with interest sensitive stocks such as utilities faring the best. Commodity prices may also begin to decline. It may be time to load up on long-term bonds, which rise as interest rates drop.

Asset Allocation Scenarios

What should be in your portfolio? That depends on your age, risk threshold, personal financial situation, investment goals, the current economic circumstances—and, perhaps, most importantly, how well you want to sleep at night.

Some aggressive investment advisors recommend that stocks constitute as much as 95 to 100 percent of an investor's portfolio because of the superior long-term track record of stocks over other types of investments. Wall Street researchers have done numerous studies on asset allocation theory, with bell curve charts and asset charts and risk-return graphs. Basically what they show is for pure performance, the longer the time frame, the heavier the weighting in stocks, the better the total return. But maximum total return should not necessarily be your goal. Safety should have a role in your portfolio, as well. Stock growth may look great on the charts, but not all stocks meet the averages. As we learned in the tech stock meltdown, investing in the wrong stocks can have a devastating effect on your portfolio.

That’s where asset allocation comes in. Following are some asset allocation scenarios designed to give you some ideas on putting together your own portfolio.

Investing for growth.

Ages: 20 to 39. Stocks and stock mutual funds or stock unit investment trusts should dominate your portfolio, comprising 50 to 80 percent of your investment assets. To balance out the portfolio, look for other high return investments from different asset classes. For instance, REITs or real estate limited partnerships would be a good place to park 10 to 20 percent of your assets. You might also put 10 to 20 percent in high yielding junk bond funds or UITs, mortgage-backed securities, and convertible bonds. They all offer above average returns while providing additional diversification for your portfolio.

Ages 40 to 50. Your time horizon to retirement is still long enough that stocks should continue to be a crucial part of your portfolio. If you’re still investing for growth—as most people are in the 40 to 50 age range—you should stay aggressive. Stocks could comprise as much as 50 to 75 percent of your portfolio. REITs and real estate limited partnerships could account for 10 to 20 percent, and junk bond funds or UITs, mortgage-backed securities, convertible bonds and other high-yielding income investments (or zero coupon securities) could also account for 10 to 20 percent of your assets. However, getting a little more conservative as you get older, you might opt for some slightly more conservative assets, such as corporate bonds, STRIPS, TIPS or a bond UIT or mutual fund.

Ages 50 to 60. Your time horizon before retirement is shrinking so you should consider taking a slightly more conservative approach. But, remember, it may only be a few years before you retire, but it could be many decades before you die. You need to maintain a portfolio that will continue to grow for many years after you retire. Stocks should still be a key component, comprising 40 to 70 percent of your assets. REITs and real estate limited partnerships could account for 10 to 30 percent, and fixed income investments could account for 25 to 50 percent. If possible, keep a broad range of fixed income investments, including junk bond funds or UITs, mortgage-backed securities, convertible bonds, zero coupon securities, investment grade corporate bonds and funds, savings bonds, STRIPS, TIPS and I-bonds.

Age 60 to retirement. You’re winding down your risk level, but while you only have a short period to retirement, you may still be living for several more decades. One of the biggest mistakes retirement age people make is that they become too conservative with their investments, taking a short-term approach instead of planning for the long-term. They pull their money out of stocks and stock mutual funds and put it into CDs, bonds and U.S. Treasury Bills. Those income-bearing investments may pay decent interest rates in the short-term, but they provide no long-term appreciation. And, unlike a typical stock dividend that tends to rise with inflation, bonds and CD payments do not increase. If all your money is in conservative investments, your buying power will be slowly eroded by inflation. You should continue to keep a good share of your assets in stocks and stock funds—maybe 30 to 60 percent, with heavier weighting going to more conservative, dividend-paying blue chips. Then keep your risks down and returns up by spreading your assets across a range of other investments, such as REITs and real estate limited partnerships (10 to 20 percent), corporate bonds (or UITs or funds), junk bond funds or UITs, mortgage-backed securities, convertible bonds, zero coupon securities, savings bonds, STRIPS, TIPS, I-bonds and T-bonds.

Investing for income

If you don’t need growth, but you do need income, your portfolio might look something like this:

25 to 50 percent stocks, heavily weighted with dividend-paying blue chip stocks and utilities (or stock mutual funds or UITs that invest in dividend-paying stocks (those dividends will continue to climb helping you maintain your buying power to counteract inflation; 15 to 30 percent in REITs and real estate limited partnerships; and 40 to 60 percent in a wide range of fixed-income investments, such as corporate bonds (or UITs or funds), junk bond funds or UITs, mortgage-backed securities, convertible bonds, I-bonds, T-bonds and tax-free municipal bonds.

Investing for preservation of capital

You’re already wealthy and set for life, as long as you don’t lose the money you’ve already accumulated. And that is a big concern. Many investors made enough in the high tech stock market of the 1990s to be set for life. Problem was, they got greedy and kept too much of their money in the stock market instead of spreading it around. When the market tumbled, so did their portfolios. A million-dollar nest egg suddenly became a half a million or a quarter million-dollar nest egg—not enough to be set for life. Once you’ve accumulated a solid investment nest egg sufficient to get you through retirement, why take chances. Time to trim back the riskier assets and pump up the safer ones. But you don’t want to lose ground to inflation. You want to maintain your buying power without jeopardizing your fortune.

Since stocks still provide the best returns over the long term—and may pay pretty good dividends that keep moving up, keep 20 to 40 percent of your assets in a well-diversified portfolio of blue chip stocks or funds. That may seem like a high percentage, but mixed in with a number of other diverse investments, it shouldn’t pose too big of a drag in a down market, and could bump up your returns in a bull market. Add some REITs or real estate limited partnerships (10 to 20 percent), with the balance of your assets going into a combination of fixed-income and zero coupon investments, such as corporate bonds (or UITs or funds), junk bond funds or UITs, mortgage-backed securities, convertible bonds, zero coupon securities, savings bonds, STRIPS, TIPS, I-bonds and T-bonds.

Or, if you want to keep your income taxes down, you might put 20 to 40 percent of your assets in municipal bonds. They won’t provide any capital appreciation, and their yield is among the lowest of all bonds, but the interest is tax-free, and the rates tend to be somewhat higher than inflation, so you can maintain buying power.

Tweaking Your Portfolio

You can increase your long-term returns if you are able to make occasional adjustments in your asset mix to take advantage of changes in the economy. Here are some suggestions on how to tweak your portfolio as economic circumstances change:

• The economy is slowing and interest rates are high: Time to move some money out of stocks and into fixed-income investments while you can still get good yields. Put more into long-term bonds (or funds or UITs), zero coupon bonds, and mortgage-backed securities. Interest rates tend to fall during an economic slowdown, increasing the value of existing fixed-income investments.

• The economy is beginning to recover and interest rates are low. Time to move some money back into stocks and commercial real estate investments, such as REITs and limited partnerships. Lighten your position in fixed income investments, because they tend to decline in value as interest rates increase. If you need income, put some money into TIPS (Treasury Inflation-Protected Securities) and I Bonds that increase their yield as inflation picks up. Convertible bonds might also do well now, and you might also put some money into U.S. Savings Bonds because the interest rate they pay increases as market interest rates increase. You might also want to put some money into other types of investments that do well in inflationary periods, such as oil and precious metals.

• The economy is in full swing and interest rates are moving up. Stocks and real estate investments are still going strong, so hold onto those investments. Oil and precious metals may be near a peak (sell the metals, hold onto the oil for a little longer). And fixed-income investments are beginning to look more appealing. Hang onto your TIPS and I Bonds, but you might want to start moving a little money into the higher-yielding fixed income investments, such as junk bond funds, corporate bond funds, and mortgage-backed securities.

• The economy is starting to slide, and interest rates are high. The cycle begins again. Lower your exposure to stocks and real estate, and begin to lock in fixed income investments at the current high rates.

Because of the uncertainty of the economy, you need to be very careful in the changes you make to your portfolio—just make small adjustments from time to time. It’s impossible to anticipate with great certainty the extent of upcoming economic shifts and their impact on various assets. That’s why it’s important not to make radical changes in your portfolio. Hang onto your basic core components, and make minor shifts in the weighting. Or as Pope John XXIII once put it, "See everything, overlook a great deal; correct a little."