Asset Allocation has been shown to be the dominant (90%+) driver of portfolio returns, with stock selection playing a smaller role. Asset Allocation represents a mix of two types of assets: Productive Assets and Stores of Value. The relative mix of these two types of assets can be thought to be driven by the investor’s longer term outlook on monetary inflation, aka debasement of fiat currencies.
Productive Assets generate cash flow, which can be valued using a conventional discounted cash flow model. Stocks, bonds, interest accounts, REITs, are all considered productive assets. Cash flow is denominated in sovereign currency, e.g. US dollar, and consequently subject to monetary inflation. Conventional wisdom has been to maximize mix of productive assets in the portfolio (e.g. 60/40 stocks/bonds). However, if the value of productive assets selected for the portfolio is not projected to outpace monetary inflation, then that portion of the portfolio is unlikely to protect or grow wealth over the long run.
Stores of Value (SOV). When wealth needs to be preserved over a lifetime (or multiple lifetimes) against monetary inflation, it is essential to implement a thoughtful mix of SOV assets in the portfolio. It is helpful to think in terms of five types of SOV. (a) Hard assets are hard to produce. Supply of hard assets cannot be significantly increased with increases in price, i.e. supply is inelastic. E.g. gold (and derivatives), Bitcoin (and derivatives). (b) Trophy assets are scarce assets that the wealthy will want to buy. Examples include sports teams, or certain businesses. (c) Real estate has been widely regarded as a long-term store of value. (d) Collectibles like fine art, jewelry, coins, wine, etc. (e) Fiat Currencies like the US dollar, which are needed for transactional purposes, including payment of taxes.
For asset allocation to serve its purpose of protecting and growing wealth, it is important to start with a comprehensive picture of the investor’s wealth or estate. Then think about the investment time horizon, including known calls on cash in certain timeframes. When combined with a thesis on Global Macro and monetary inflation, the investor should be in a better position to judge portfolio asset allocation of productive assets vs. stores of value.
