A reader asks the question about how much should an investor, particularly one with real estate investment trust set aside, or how much should be his asset allocation. I look at this as a question of a non-traditional stock and bond asset allocation, that is, a stock and cash asset allocation, how would structuring this be different.
The theoretical answer could be that cash and stock are very much uncorrelated. Having cash reduces the overall volatility of your overall portfolio. A market down turn of 50% will reduce a 50% stock and 50% cash portfolio by 25%. For a risk adverse investor, you will be glad that your portfolio went down by 25% (side note: sometimes you have to practice looking at your overall value of the portfolio when accounting for performance)
However, in a bull run, your performance will lag behind the general stock market.
I am of the thought that your stock and cash allocation reflects your level of risk adverseness. If you have a stomach of steel and believe in the businesses that you have selected (since you are picking individual stocks), or are able to make sensible investing decisions when needed, you can have a 100% stock allocation.
Holding cash has a big benefit for the individual stock investor, that is, its a ‘call option’ much like the derivative to allow you to purchase businesses that don’t come around often, such as when they have a misunderstood earnings disappointment, an overall bear market, a flash crash.
Without cash, that is, if you are 100% allocated to stocks, you can still purchase businesses in these scenario. You would have to compare the reware and risk of those stock businesses you currently own with the opportunity during these rare moments. An example would the stock A in your current portfolio fell by 20% in an overall bear market, but going forward you derive that the intrinsic value of stock A is less than the intrinsic value of stock B at current share price, which you do not owned. You can switch out and purchase some of stock B. Evaluate with less endowment effect but as an investment going forward. Instead of rebalancing to cash, you rebalance to more attractive shares.
Cash is a problem in that they yield too little as compare to stocks and bonds. While bonds are very lowly correlated to stocks, their long term returns tend to be better and more significant. As such my advice is that in a baseline average market, don’t hold more than 30% cash.
If you invest in REITs, the 30% should be enough for rights issue, if that is not enough, depending on the attractiveness, you an sell your rights in the open market. While you may lose some value, it is better than letting it expire and not buying it.
My current cash allocation is 42% based on cost, but based on value its closer to 36%. I subscribe to the idea that I am inherently risk adverse and I would be more comfortable investing in things that I do know at the comfortable valuation, they forcing myself to invest just for the allocation.
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