Asset Allocation

Asset allocation is the master blueprint for your investment portfolio. Think of it as deciding how to slice your investment pie among different categories, known as asset classes. The most common slices are stocks (owning a piece of a business), bonds (lending money for interest), and cash (the ultimate safety net). The core idea is to balance potential rewards with your personal risk tolerance. A young, adventurous investor might have a huge slice of stocks, while someone nearing retirement would prefer the stability of more bonds and cash. It’s not about picking individual winners but about setting a broad strategy to manage the ups and downs of the market over your time horizon. While financial advisors often call this the single most important decision, many value investors argue that what you own is far more important than the exact percentages.

Understanding your building blocks is the first step. For most investors, the world of assets boils down to three main categories.

When you buy a stock, you're buying a small piece of ownership in a real business. If that business does well—growing its profits and creating value—the price of your stock should, over time, reflect that success. Stocks offer the highest potential for long-term growth, but they come with the highest volatility. Their prices can swing wildly based on company news, economic data, or plain old market panic.

Buying a bond is like giving a loan. You lend money to a government or a corporation, and in return, they promise to pay you back on a specific date (the maturity date) while making regular interest payments along the way. Because these payments are predictable, bonds are also known as fixed income instruments. They are generally much safer than stocks but offer lower returns. Their main job in a portfolio is to provide stability and income.

This is the money you keep in the most accessible and safest places: your bank account, money market funds, or short-term government debt like Treasury Bills. These are known as cash equivalents. Cash won't make you rich—in fact, after inflation, it often loses a little purchasing power each year. Its purpose is safety, liquidity (the ability to spend it quickly), and, for the savvy value investor, to act as dry powder for future opportunities.

If stocks have the best returns, why not put all your money there? The short answer: because we aren't robots, and gut-wrenching market crashes are hard to stomach.

The primary goal of asset allocation is diversification. Different asset classes often behave differently at the same time. When the stock market is plummeting, high-quality government bonds often hold their value or even go up as investors flee to safety. By owning a mix, the disastrous performance of one asset can be cushioned by the steady performance of another. This doesn't eliminate risk, but it smooths out the journey, making it more likely you'll stick with your plan instead of panic-selling at the worst possible moment.

Your asset allocation should be a mirror of your life.

• Young Investor (30s): With decades until retirement, you can afford to take more risk for more growth. A portfolio might be 80% or 90% in stocks.
• Nearing Retirement (60s): Capital preservation is now key. You need your money to be there for you soon. Your allocation might shift to 50% stocks and 50% bonds and cash.

Here’s where capipedia.com’s philosophy comes in. While traditional finance obsesses over precise percentages, value investors see the world a bit differently.

The father of modern finance, Harry Markowitz, developed Modern Portfolio Theory (MPT), which uses complex math to praise wide diversification. But legendary value investor Warren Buffett has a different take: “Diversification is protection against ignorance. It makes very little sense for those who know what they're doing.” A value investor prefers to own a concentrated portfolio of 10-15 wonderful businesses they understand deeply, rather than a shallow ownership of 500 average ones. For them, deep knowledge is the ultimate risk-reducer, not owning a little bit of everything.

For a value investor following in the footsteps of Benjamin Graham, the process is bottom-up, not top-down. They don't start by saying, “I need 70% in stocks.” They start by searching for individual, high-quality companies trading for less than they are worth (with a margin of safety). The resulting “asset allocation” is simply a consequence of where they find these bargains. If all the great opportunities are in stocks, their portfolio will be heavily weighted toward stocks. The focus is on the quality of the individual asset, not the category it belongs to.

In a traditional asset allocation model, cash is boring. For a value investor, cash is king. It represents optionality—the power to act when others are forced to sell. Holding cash allows an investor to be, as Buffett advises, “fearful when others are greedy, and greedy when others are fearful.” When the market panics and sells off wonderful businesses at silly prices, the value investor with a pile of cash can go shopping for lifetime bargains.

So, what should an ordinary investor do?

1. Know Thyself: First, be honest about your ability to handle market swings. If a 20% drop in your portfolio will cause you to lose sleep and sell everything, you need a more conservative allocation with more bonds and cash, regardless of your age.
2. Start with a Simple Rule, Then Question It: A common guideline is the “100 minus your age” rule, where the result is the percentage you should have in stocks. For a 40-year-old, that's 60% stocks. It’s a decent starting point, but don't follow it blindly.
3. Rethink Rebalancing: Traditional advice tells you to perform rebalancing—selling assets that have grown and buying those that have shrunk to return to your target percentages. A value investor might ask, “Why would I automatically sell my best-performing business just to buy more of something that's doing poorly?” A better approach might be to add new investment money to the underweighted categories rather than trimming your winners.