A Simple And Effective Portfolio Allocation Strategy

by: Tam Ging Wien


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This week, we would like to introduce our readers to a simple and effective method thinking about your investment portfolio allocation strategy. We call this the 3 money bag strategy.

 

The 3 money bag strategy is a portfolio balancing concept which allows investors to segregate their investments into 3 key classifications:-

  • Long Term Strategic Fund (Strategic)
  • Medium Term Tactical Fund (Tactical)
  • Opportunity Fund (Opportunity)

The 3 money bag strategy assumes that the funds in all 3 bags are used purely for investments and all necessary expenses have been set aside. These funds are for compounding wealth over the long term.

The Strategic funds are used to invest in asset classes which can be considered defensive, non-discretionary and long term in nature. Real estate, healthcare, high dividend stocks and REITs are examples of investments in this portfolio. Funds invested should continue to provide investors with a steady stream of income regardless of economic seasons.

The Tactical fund should be allocated to asset classes which are discretionary in nature and provide a more significant upside potential during heightened economic growth. Investors have an eye to spot changes in the economic cycle and exit these investments at the appropriate market season. Investors take a greater risk in this tactical fund with potential for a much larger growth.

The Opportunity fund is where investors park their money in cash or in high quality bonds which can be liquidated easily. All passive income received from both the Strategic and Tactical fund should be allocated here for reinvestment in the future.

The Opportunity fund is based on the principle of maintaining some cash and liquidity in the portfolio is so that investors are equipped and ready to take opportunity when they come across a high quality and undervalued investment. This fund should continue to grow over time due to accumulation of passive income and an investor should draw down on the funds during opportune moments.

In a completely balanced portfolio, an investor would have an allocation of 34%, 33% and 33% to the Strategic, Tactical and Opportunity fund respective.

However, the 3 money bag strategy can be adjusted according to the risk appetite of the investor as well as the economic environment that we are presently in. A table below illustrates the various suggested allocations by percentage that an investor could consider:

A person can opt for a particular risk appetite depending on age, fund size, economic season, personality and investment objectives.

For example, an investor who is close to retirement and whose primary purpose of investing is to preserve their wealth and generate passive income should opt for a conservative fund allocation.

In the case of a young professional whose primary purpose is to grow their wealth and compound their asset value could opt for a Growth or Aggressive fund allocation.

Investors who are relatively new to investing could consider a Balanced fund allocation.

One important aspect when considering the percentage allocation within the 3 bags is the current economic environment. Right after emerging from a recession, an investor could consider and "Aggressive" portfolio allocation. However, if we deep into a long bull run, investors could consider a "Conservative" or "Risk Adverse" portfolio allocation.

What Allocation Should We Consider Now?

According to data from National Bureau of Economic Research (NBER) which tracks the data of the US Business Cycle Expansions and Contractions, the US experienced 12 major economic recessions since World War II. Each recession last on average 10.83 months. The longest being the Global Financial Crisis in 2008 which lasted over 18 months!

Source: US Business Cycle Expansions and Contractions, National Bureau of Economic Research (NBER)

More interestingly is the average duration from trough to peak which gives us an indication of how long an economic expansion will last. On average, it is approximately 60 months or about 5 years. The longest economic expansion was from November 2001 to December 2007 lasting about 120 months or about 10 years – double the average!

Source: US Business Cycle Expansions and Contractions, National Bureau of Economic Research (NBER)

As of January 2017, we have completely a full 103 months of economic expansion, 3rd longest in history since World War II and surpassing the average by more than 40 months.

Recently, we have had a lot of positive news emerging the in markets lately with economic expansion at a record pace, stock markets at historical highs and record earnings announcements from the multi-national firms. 

However history tells us that the party cannot go on indefinitely. What goes up, must come down and we are definitely moving much closer to the start of the next recession.

Hence, looking back at history, it does seem that we are in a long than average season of economic prosperity. However, history has shown that recessions are a natural part of the economic cycle.

Recently, the stock-market started a brutal sell-off. At this moment, it is not clear if this is just a minor correction in the bigger scheme of things or just the start of a multi-month stock-market downstrend.

As we are deep into the current economic prosperity and equities are still overvalued despite the recent sell-off, investors should consider a "Conservative" or "Risk Adverse" portfolio allocation. Allocating significant amounts to cash reserves and scaling down on tactical investment selections would be wise in this current economic environment.

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