Pirates and Hippies – lessons on Asset Allocation and Asset Location

If you can understand the essence of a concept, it is much easier to fit the pieces of the puzzle together and understand higher level aspects of it.  Let’s explore Asset Allocation, and its twin Asset Location from the ground up for a change.  The greatest issue that society faces today is the depth of confusion within the financial world, in its instruments and obligations.  But us humans have been storing things of value since time began.

• Asset Allocation refers to the type of asset you are storing your wealth in.
• Asset Location refers to where you physically (or conceptually) store that asset.

What came first, the Chicken or the Egg?  In the case of wealth, you must always first perform Allocation, and then Location.  Your wealth must first have a name, before it can have a home.  For example, if you wanted to buy 1000 shares of Ford stock in your retirement account you must first buy the stock, then put it in the retirement account.

That statement sounds confusing and inaccurate due to the rules we have created on retirement accounts, so try to consider it only as a concept for now.  In reality, if you wanted to buy 1000 shares of Ford in your retirement account you would have to first send over Cash to the account (or liquidate another asset already inside it), and then buy Ford with the Cash.

The reason that I am asking you to suspend belief is that we must not fall into the trap of thinking that Cash is the key here.  Cash is in fact another Asset.  Cash stored in a Checking Account is an Asset Allocation with an Asset Location.

Can we get all groovy for a moment?

In the spirit of the 1970’s and free love I’d like us to think of wealth as energy.  We trap it into assets, but it comes from things like hard work, or savvy transactions.  It’s kinda neat to think of it as energy as it also helps us understand efficiency too.  When the energy transfers from one form to another some energy is lost, in physics this is commonly in the form of friction or heat loss.  For a financial example, if you sell your home you start out with your accepted sale price. However, once you start cutting checks to the Realtor, to the City, the State, the co-op board, you end up with a lot less than anticipated.  The transaction of changing the energy from one form to another has loss.

The reality here again is that it doesn’t have to, these are all constructed things, and the prices are set not based on actual work, but on arbitrary measures.  For example, I forgot to bring one 7 page document to my closing last week and the co-op board fined me $300 because they had to spend 30 seconds bringing up a copy from their filing cabinet.  What we see though, are attempts in the corporate and financial worlds to mimic natural events.  Learn to understand the nature of the beast, and you can learn to understand how smart people have tried to use that to manipulate your money over time.

One critically important part of thinking of wealth as energy is that it means you don’t get tied to a specific currency.  Many people think the Dollar is King, but a savvy long term strategy would be to have assets that are not 100% tied to the Dollar.

Going back to that Ford stock for a moment, you can see it really is Allocation before Location:

Energy>Cash>Retirement Account>Ford Stock AKA Wealth>Allocation>Location>Allocation

Diversification is the reason for Asset Allocation

Asset Allocation by its very nature implies more than one option.  If you had no options you couldn’t really decide on allocation, it would be allocated for you into the only option available.  It is widely accepted that the best wealth preservation tactic is diversification.  Having all your eggs in one basket is a risky thing, though people also argue that they can do more with a basket full of eggs, and acquire more from a narrow or undiversified wealth strategy.

Bring in the Pirates

We went to the 1970’s already, lets go back a bit further to the time of Blackbeard and the Pirates.  Picture a damsel in distress- her ship was about to be boarded by these dastardly pirates.  While a bit late, a last ditch effort to diversify may be made in order to protect the wealth.  This would be Location diversification, she might slip a large Ruby into her Drawers, a Gold Doubloon into her boot, and some shekels into her pocket.  Here we have three different asset allocations and subsequent locations in order to protect existing ‘wealth energy’.

Let’s say the three assets have the following value: 1 Ruby = 5 Gold Doubloons, 1 Gold Doubloon = 10 Shekels,  0.1 Shekel =1 Pint of ale

If she managed to escape these Pirates and return to land, there would be many other issues to factor in.  The Ruby offers a store of wealth, but due to its value has low liquidity if you ever make it to the pub, she’d get robbed again, this time in the energy transfer rate of wealth.  If you are paying for a pint with a Ruby then you have the wrong asset allocation, and will be forced into a fire sale.  This is akin to storing too much wealth in the market, without a cash reserve for emergency funds.

However, she couldn’t rightly wander around with a sack of Shekels all the time either, both for practicality and also for risk management reasons.  It is easy to locate a Ruby in a way to protect it from Loss/Theft risk, less so a sack of jangling coins.  This shows the power of diversification for asset allocation.

Correlation, the Scourge of Asset Diversification

Despite our damsel allocating wealth in 3 different classes (Ruby, Gold, Shekels) and locating them in 3 different areas (Drawers, Boot, and Pocket) there is a serious problem in the form of correlation.  All her assets, regardless of allocation are subject to location risk.  Should the Pirate force the Damsel to strip naked, and all wealth will be revealed (yes I meant those drawers..) the correlation at play here is the physical location of the assets, and this single weakness puts everything at risk.  It is my view that as the world is increasingly connected, that asset classes are likewise increasingly correlated, and removing correlation risk is a very complicated thing indeed.

Going back to the notion of wealth being energy that can be created and later stored, the vast majority of your wealth can come from potential future earnings, from your career or business ventures rather than investments.  With that in mind it is very important to create investment strategies that hedge around your earning potential.  For example, if you earn money as a carpenter, don’t invest in lumber.  If a new pest enters the ecosystem that wipes out lumber supplies, not only is your career (wealth generation) but also savings are wiped out.

Even though it seems contradictory, I’d argue that certain correlating investments can be a prudent measure also, the key is find ones that protect against external risks.  One example of this in action would be Delta Airlines acquiring an oil refinery as a hedge against rising fuel prices.  The reason why this investment works is that while it is correlated, it is negatively correlated.  If fuel prices fall then profits rise for the airline, and they can stockpile their own inventory.  When fuel prices rise they can dip into this fuel surplus.  So correlation isn’t bad if it is strategically placed negative correlation, but knowing the difference can trip people up.  The key here is to look at your overall financial position in terms of a SWOT analysis, and allocate assets to offset Threats and Weaknesses.

Conclusion

Before embarking on an asset allocation and asset location strategy think back to the very basic principles. There is a tendency to take snippets of data and ‘facts’ from quasi experts in the field of finance, go back to principles.  I’d argue taking these concepts even further back, as far as you could imagine – how would a hunter store their kill? Eating some now, storing some for later, trading some for other produce.  This is the root of allocation and location, understand it before you wonder about the market.

The most widely discussed asset allocations are Cash, Bonds, Stocks, Real Estate -but don’t get trapped in the mindset of thinking that this is all there is, and that one will always protect the other.  The most widely discussed asset locations are a simplified view in the US between tax favored and non tax favored accounts (such as IRAs vs a normal Brokerage account) but this too is a narrow mindset.  Both the allocation and location concepts we see most commonly are trapped by being pegged to a certain correlated factor, sometimes too closely for true diversification.  Whether that market be the US Economy, or the underlying US Dollar, let’s remember to think bigger than that when visualizing our assets.