Functional Asset Allocation
Using Functional Asset Allocation, your assets should be distributed
across three asset classes to accomplish specific purposes:
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Interest Earning consists of two broad asset types (Cash and Bonds) and
serves the purpose of Capital Preservation. We want to be sure you have adequate
cash flow, regardless of what happens in the financial markets, in order to maintain
your standard of living for a given period of time. In the early stages of the Financial
Life Cycle, we recommend you accumulate enough in this asset category to provide
six to twelve months of liquidity, before making long term investments. In later
stages of life, our formulas are structured to provide a sure cash flow for ten,
twelve or even fifteen years. The appropriate attention to Capital Preservation
in each stage gives you POM (Peace Of Mind) when you build Cambridge Model Portfolios.
To assure maximum tax efficiency, we recommend using primarily retirement assets
to fund this category, except for the amount needed for day-to-day liquidity.
-
Real Estate is divided into three asset types:
- Personal Residence
- Productive(including REITs and rental property), and
- Non-Productive (such as vacant land,
second homes and passive limited partnerships). The unique functions of real estate
include personal use and enjoyment (as discussed previously), and the opportunity
to leverage by mortgaging the property. Positive financial leverage through a home
mortgage provides Americans with the most advantageous after-tax investment vehicle
in the world. This is why we place so much emphasis on this asset class relative
to what most investment managers recommend.
-
Equities includes four asset types:
- Domestic mutual funds,
- International funds and Gold bullion (which hedge the dollar),
- Individual Stock holdings (segregated because of the higher volatility with little
diversification), and
- Stock/Options from an employer (which carry a clear market advantage when purchased
at a discounted price).
Equities are the growth engine, but subject to the most volatility. Most standard
asset allocation approaches ignore the reality that company stock plans are the
driving force (requiring careful tax management) in the portfolios of many employees,
and that "recreational investments" in stocks carry a different risk component because
there is usually not enough money to adequately diversify. We recommend using non-qualified
assets invested in passively managed or index funds to take advantage of low turnover
and favorable capital gains tax rates.
Non-Marketable
is our term for assets that are either very illiquid (hard to convert to cash) or
generally not suitable for the vast majority of investors. The most common assets
in this category include your personal belongings in A5 and jewelry, antiques, investment
grade art, collectibles, a closely held business and limited partnerships in C2.
The analogy of the farmer is useful for understanding the
separate functions of the three major asset classes. The interest earning asset
class is what the farmer puts in the root cellar to feed the family during a bad
winter or reseed his fields after a drought. The real estate asset class which is
primarily your home is the equivalent of the farmer’s garden. The garden provides
food to eat and flowers for enjoyment. The equity asset class is the equivalent
of the farmer’s fields. The fields are the farmer’s engine for growing wealth. The
larger the fields and the more productive the crops, the faster his wealth grows.
After you become familiar with it, your pyramid becomes
a very powerful tool for understanding at a glance your personal financial status.
Pyramid Asset Classes
Pyramid Asset Functions
