Strategy Sessions- Part 1: Overview of Asset Allocation Versus Individual Securities

Steve brought up an interesting fundamental debate that investors have to resolve in their own heads: Should I be a stock picker or should I focus on asset allocation?

To put my own chips on the table here, I do both. Yes, it's a cop-out, but at the same time there is some value in it. Spreading your bets around not only different securities, not only around different asset classes, but even among different strategies does reduce the possibility of catastrophic loss and that is one of the chief objectives that any individual must bear in mind when making investments. Part of the reason I pick individual securities is that it simply keeps me interested in the market. The other reason is that I firmly believe that, with a good research methodology based on the fundamental value of companies, you can beat the market. However, I made my peace with the idea that I will not always beat the market and a lot of people do not come to terms with that.

As to the issues regarding picking individual securities, you must have a stomach of steel to handle the volatility. I own upwards of 18 different stocks at any one time so a large move in any one of them does not usually phase me. However, this sort of environment is not appropriate for many people for any number of reasons. Quite frankly, there is nothing wrong with being uncomfortable with high levels of volatility. It's a natural human reaction. If you do not feel able to keep up with the pace of the market, I would recommend broader strategies that focus more on asset allocation. Quite frankly, there is a damn good chance you will actually do better than being a trader or a stock picker. There's a great deal of evidence from economists and financial historians to support that idea.

To that end, I have devised a dynamic asset allocation tool designed to allocate into appropriate levels of stocks and bonds based on credit market indicators. The basic theory is that credit markets give indications of when you should get in and out of the market. I have always believed, with substantial empirical research from countless economists to support this belief, that interest rates are vital market signals and that relationships between different interest rates and those interest rates versus equity prices can be valuable investing tools. The model I have worked on will need revision as time goes on, but I think the general premise is solid.

In a few future posts related to this broader subject I will:
1. Discuss the dynamic asset allocation model introduced here
2. Outline some reasons why some individual stock holdings may be more subject to volatility than others
3. Introduce some methods for reducing volatility while still leaving open possibilities for gains
4. Whatever else I might think of

I'm doing this somewhat backwards because I am actually somewhat giddy to share the dynamic asset allocation model.