Asset Allocation: The Starbucks Approach To Your Investments

We often talk about diversification and how we allocate your money into many different asset classes. This is one of the most fundamental principles to successful investing. A real life experience, totally unrelated to the stock market, can help to explain the concept.

When you walk into a Starbucks, you notice that they sell much more than black coffee. The menu has expanded over the years and includes many items that you often wouldn’t order together. For instance, a café latte and an iced cappuccino would rarely, if ever, be ordered together. Many times the café latte will be ordered on a cool day and an iced cappuccino on a hot summer day. By selling both items, Starbucks knows that it will have a drink for whatever the customer is in the mood for. By selling both drinks, or by diversifying the product line, Starbucks can reduce the risk of losing money on any given day and increase their chances of making money.

This basic understanding of diversification leads us to the practice of asset allocation. Asset allocation is the process of dividing your money amongst different asset classes, such as bonds, stocks, and cash. Deciding the proper mix of assets within your portfolio will depend largely on balancing your goals and risk tolerance.

In the last article, we discussed why we allocate your assets to the different types of accounts (OS, ST, LT and retirement accounts) to help meet your goals. Here, we’ll go into how we make decisions to allocate money within these portfolios.

When allocating money within your portfolio, we have many investment choices. At a high level these choices include cash, US bonds, international bonds, US stocks, international stocks, and alternatives such as real estate, natural resources, precious metals and commodities. Historically, the investment returns of these asset categories don’t move the same under different market conditions. So, much like the different product offerings at Starbucks, a portfolio that holds different asset categories increases the chances for return and protects against significant losses. Thus, a portfolio holding investments in more than one asset category reduces the risk that you will lose money and your overall investment portfolio’s return should be smoother. This spreading of money amongst different asset classes to reduce risk is the classic definition of diversification.

Now that we know the importance of diversification the question becomes: how much do we allocate to the different asset categories? The allocation of money amongst different asset categories is vital to determine the likelihood that you will reach your goals. If you don’t include enough risk in your portfolios — for example, holding all cash — then you will likely have trouble keeping pace with inflation (purchasing power of your money), let alone growing your money to meet the cost of your goal when you want to purchase it in the future. However, if you include too much risk in your portfolio then there could be a chance that your money won’t be there when you need it.

This is why we spend a great deal of time identifying your goals and then managing your investment portfolio according to those goals. For your short term goals we focus on investments that traditionally produce the highest return for the least amount of risk. This portfolio allocation primarily consists of bond investments. We choose to use bond investments because historically these investments are very stable in price while producing some income to/for the investor.

As your goals become longer term we know that we must look to increase the return on the portfolio while still maintaining a reasonable level of risk. The necessity of growing your portfolio to outpace inflation and growing your money to meet long term goals means that we must allocate some of your portfolio outside of bond investments. In these Long Term accounts, we invest your money into asset classes including cash, US bonds, International bonds, US stocks, International stocks, real estate, precious metals, and natural resources. By having a mix of these assets in your portfolio we are increasing the likelihood that your portfolio will grow over time to meet your long term goals. The proper mix is determined by our Investment Committee, who has studied the current market conditions and evaluates the risk and return relationship of every investment within the portfolio. While we cannot eliminate the risks of losing money, our goal is to determine the best possible allocations to provide a return that compensates our investors for the risk that is being taken.

In our next article, we’ll dive a bit deeper into the different asset classes and even some of the sub asset classes that we use in our portfolios.