What is a Recipe?
A list of ingredients, with specific instructions on how much of each ingredient and specific instructions on what to do with them, in order to achieve the goal of making a cookie.
What is an Asset Allocation?
A list of investments, with specific instructions on how much of each investment and specific instructions on what to do with them, in order to achieve a financial goal.
Ingredients:Both recipes and asset allocations require ingredients.With a cookie, it’s usually butter, sugar, eggs, flour, baking soda, chocolate chips, & salt.One of the key ingredients with a cookie, that many are surprised about is the salt.However, if you leave the salt out of a cookie, it doesn’t taste good.You see, you can’t just add sugary ingredients.The same can be said with a properly designed asset allocation.If you just include highly correlated investments, where everything goes up at the same time, it usually means they would all go down at the same time.Diversification essentially means always having to say you’re sorry.Namely not everything in a properly designed asset allocation will be performing at the same levels at the same times.
Instructions:Recipes involve following a set list of instructions to mix the ingredients in a certain order and then to bake them for a set time frame.Asset allocation is the same, you need to mix the investments, and let them ‘bake’ or stay invested for a set period of time.And just like with a cookie, if you take it out too early, it won’t taste as good.Same with your investments, selling long-term investments too soon will not work out well.The same can be said if you leave a cookie baked too long, it will burn.Same with your investments, if you leave your aggressive investments in too long, you could get burned if you need to access them closer to your goal.That is why ongoing active management of an asset allocation is key and needs to always be tied to your goals.Just like a recipe, you don’t want to get a cookie recipe if you’re trying to make a stew.The recipe has to be directly tied to the end goal, same with an asset allocation, goals drive everything.
Buying the Ingredients:When following a recipe, you first need to search for and buy the ingredients.You can go out and shop for the best flour, the best sugar, butter, chocolate chips, etc.. and then find an average run-of-the-mill recipe.The same can be said with an asset allocation, historically this is the typical way one would build an asset allocation.They spend the majority of their time trying to find the ‘best’ investment for each category.For example, searching for the best large-cap growth fund, large-cap value fund, or small-cap fund, etc.And then those investments are placed in an average stock/bond allocation.
For example, if someone wanted to have a moderate risk tolerance, they might target 50% stocks & 50% bonds.We believe this is a less-than-optimal approach, with little alpha being able to be produced.
Refer to our blog titled: “The ABC’s (Alpha, Beta, Correlations…) of investment fund analysis” for details on alpha of other important investment terms.
Another approach to a recipe/asset allocation is to just get average ingredients/investments and then find an amazing recipe/asset allocation. This is similar to buying index funds & ETFs and then trying to build an amazing asset allocation. This can require significantly more time to properly manage the asset allocation, especially if it is a more active allocation.
We think it’s possible to combine the two, find amazing investments, and also build an amazing asset allocation. Just like with a cookie recipe, if you find amazing ingredients, and combine that with an amazing recipe, you get one amazing cookie!
But we would ask, as people that enjoy cookies, why just stop with one type of cookie recipe? Why just get a chocolate chip? Why not also make peanut butter, macadamia, caramel, gingerbread, etc? The same can be said with asset allocation(s). There are many different approaches to asset allocation, and by just building and following one asset allocation approach, you are dramatically minimizing your likelihood of success.
We call our approach Multi-Dimensional Asset Allocation. By utilizing different allocation approaches within a larger primary allocation, one can dramatically increase the level of diversification within their portfolio. The main goal of an asset allocation is to help smooth out the return experience, thus increasing the likelihood of sticking with the investment program, and hence realizing one’s goals.