What a year the investment markets have had. This time last year most capital markets were hopelessly looking like it was all over and today it all looks rosy. Throughout it, we were bombarded with all kinds of contradicting opinions and outlooks, and in this kind of environment investment decisions become very hard. Proper decisions in times like these are important because they will make a big difference in the long term returns of a portfolio, especially when there is so much fear in the system. As an advisor I also have an opinion, because after all my opinions are at the core of my investment strategy. However I also understand that opinions could be wrong and therefore I have learned not to be espoused to my opinions and to be ready to take action. This is important because even though my long and mid term outlook might be correct, on a short term basis markets do not tend to move in a linear fashion. Therefore, I must be ready to adjust my portfolio accordingly. However, I have learned that the best performance of a portfolio comes from maintaining an adequate balance between the different asset classes depending on the current investment climate, and this is called asset allocation. In this piece I will review the asset allocation of my portfolio throughout the last two years so that you can gain a better understanding of the money management process.

Asset allocation is important because it accounts for 80% of the long term returns of a portfolio. Asset allocation also balances the risk spectrum of the portfolio with the risk spectrum of the individual investor. What is asset allocation? Simply put, it is the balance of the portfolio between the different asset classes such as cash, fixed income, and equity. While I may believe that the agriculture, energy, and precious metals sectors should represent the core of my portfolios, I also understand that owning appropriate levels of cash, fixed income, and other sectors of the economy will lower the volatility. Furthermore, I also understand that each client will require different levels of these components in view of their individual investment needs, level of risk, and time horizon.

Cash and short term securities are the assets that deliver the lowest level of real return, but give the highest level of capital preservation. This is the safest asset class on a short term basis. However, on a long term basis even the most risk adverse investor should be conscious of the fact that inflation is eating away at the purchasing power of this asset class. It is for this reason that I view cash as my safest shelter from the storm, but I prefer to be invested for growth. On average, over the last two years I have maintained cash levels at under 5% for 25% of the time, at around 20% for 50% of the time, and at 50% for the remainder of the time. I must mention that my most risk adverse clients have maintained cash levels at 80% for about 75% of this time, and that as of the beginning of October 2009 these clients have started to underperform as the other portfolios are surpassing the highs of 2008. This is important because the “safe play” might have to start to assume greater risk as the opportunity cost of being in cash diminishes.

Starting in 2008 I increased cash levels of the portfolio to 20% in order to address the possible volatility that was coming our way. My view was that this would reduce some of the volatility, while allowing us to take advantage of any possible sales in our investment considerations. I view market corrections as an opportunity to add to my considerations, and I need cash to invest. Cash levels were increased to 50% after the bankruptcy of Bear Sterns as I felt that this event was a catalytic change in the investment environment, and its consequences could not be fully gauged. My objective was safety and caution until the market fully priced this event. I must point out that it is rare for me to increase cash levels this high, and that on a long term basis I increase cash to about 10% to 20%. By January of 2009 I reduced cash levels below 5% as the low equity valuations gave me a compelling argument to invest. Finally, during the fall of 2009 I once again started to increase cash levels back up to 20% because of the relative outperformance of certain sectors and concerns for the market. My aim is to reduce the volatility of the portfolio, take advantage of cheap opportunities, and finally to protect the portfolio in times of extreme volatility.

Fixed income is the asset class that one uses to protect capital and for the funding of income needs. Traditionally this asset class is composed of bonds of longer term maturities than one year. However, in view of the current low rate environment, I am also including high income equities within this asset class. Global central banks are keeping interest rates very low in order to compensate for the irresponsibility of the banking sector. This policy is detrimental to funding income needs. In order to hedge I include high income equity investments such as pipelines and utilities to this asset class. My view is that no matter what happens to the banking sector or the economy, we will always have a constant minimum demand for electricity and energy. The current high yields being generated by these sectors already reflect a worst case economic scenario, which gives me comfort in the sustainability of the cash flow and the quality of the considerations. On average I have maintained this asset class at a steady 25% of the portfolio. A good strategy for the bond portion is to structure a bond ladder with different staggering maturities into the future. The discipline of always rolling the maturing investment to the longest maturity into the future will take the guess work out of anticipating future interest rates.

Equity is the asset class that delivers capital growth on a long term basis, however at times capital destruction. My approach is to make sure that I have a good understanding of the true value of the investment considerations in the sectors that I want to own for the long term. This really helps in making rational decisions in times of negative market sentiment. Currently I have identified three sectors that I think will greatly benefit in years to come; namely agriculture, precious metals, and energy. In addition to these I have some consideration in other sectors of the global economy. By building an equity portfolio within all these sectors I am left with a portfolio of fifteen to twenty equity considerations in various sectors, and I do not add a new one unless I get rid of another. My approach is to take a strategic percentage allocation in these sectors, and re-balance these percentages on a timely basis. Over the last two years this disciplined approach has allowed me to take profits many times in the various sectors, as well as given me an excellent entry point into others. For example, during the last two years the precious metals sector peaked twice due to the rise of gold up to $1000, and then broke through $1000 again in the fall of 2009. Because of this rise this sector became a much larger percentage than originally allocated within the portfolio on two occasions, and as a result I entered and sold this sector accordingly as I rebalanced the portfolio. This process gives the rational investor the discipline to sell those sectors that are outperforming while adding to those that are not. On the other hand, agriculture had a good run at the beginning of 2009 and went sideways until the end of the year, allowing me to accumulate more throughout 2009. This process is very helpful in view of the volatility of the last two years, as it helps to take emotion out of investment decisions.

The balance between cash levels and equity levels increases and decreases as I address market volatility or take profits. In the current investment environment I maintain cash levels between 5% and 20%, and will only increase to higher amounts in very extreme circumstances. When I increase or decrease cash levels in anticipation of market action I shift all equity sectors equally to reflect a lower or higher percentage of the overall portfolio, and tend to leave the fixed income portion alone. This way I do not make tactical decisions according to particular investments, but increase or decrease all equity positions. The use of an asset allocation model will give the rational investor a disciplined process by which to manage the portfolio over time; it delivers diversification, a buy and sell strategy, and takes emotion out of the equation.

Going forward I expect that the volatility will continue for many years as the world is just entering three different investment trends; a financial cleansing process called the Kondratieff Winter, a power shift from the US to Asia, and increasing competitions for hard assets. In this investment environment there will be opportunities for those with a strong understanding of history and foresight. One of the best investment principals I have learned in my twenty year investment career is that capital appreciation is created by identifying an opportunity before everybody else; when the herd figures it out it is time to move on. I am guiding the practice in a way to allocate funds to areas that offer such opportunities, and my current bullishness extends from the fact that not many have yet figured out the current investment themes. It is with great amazement that I watch the Wall Street Pundits still going on about the financial and housing sectors in the same manner that they talked about the high tech sector after the bubble burst. Maybe in future years they will also be salivating about the benefits of owning hard asset after the fact. My bullishness in this area extends from the fact that these are the things that the world will need in order to maintain quality of life, and our ability to produce them is becoming constraint.

Over the last year I have been asked many times what the high will be for the price of gold. To me the more important question is what will be the low for the dollar. It is important to understand that gold is appreciating in response to the fiscal needs of the US and other global governments; their actions are causing a continued decline of their currencies. In this environment gold is increasing as a result of devaluing currencies and should not be compared to a regular investment. Gold has been, is, and will always be the truest form of cash as it has no liabilities. Lastly, it looks like for now the US$ might have established a base and may even rise for a while, but long term the decline will continue. My take for the year ahead is that the big surprises will come from sovereign entities, supply shortages in hard assets will be more predominant, and that gold and the US Dollar will rise in tandem. Greece and many other countries are in financial trouble, and too big to fail might just be something we are saying about countries, including the US. Who will bail them out? History has shown that these kinds of situations start to solve themselves when they are allowed to fail. When this happens people will have given up and that will signal the end of this current trend. Like in the seventies, that will also be the buy signal for US assets I will be waiting for.