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Functional Asset Allocation

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Using Functional Asset Allocation, your assets should be distributed across three asset classes to accomplish specific purposes:

  1. 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.
  2. 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.
  3. 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

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