Balanced Asset Allocation E-Book

Alex Shahidi

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Wiley Finance Editions
• Sprache: Englisch

Seitenzahl: 387

Veröffentlichungsjahr: 2014

Beschreibung

The conventional portfolio is prone to frequent and potentially devastating losses because it is NOT balanced to different economic outcomes. In contrast, a truly balanced portfolio can help investors reduce risk and more reliably achieve their objectives. This simple fact would surprise most investors, from beginners to professionals. Investment consultant Alex Shahidi puts his 15 years of experience advising the most sophisticated investors in the world and managing multi-billion dollar portfolios to work in this important resource for investors. You will better understand why nearly every portfolio is poorly balanced and how to view the crucial asset allocation decision from a deeper, more thoughtful perspective. The concepts presented are simple, intuitive and easy to implement for every investor. Author Alex Shahidi will walk you through the logic behind the balanced portfolio framework and provide step-by-step instructions on how to build a truly balanced portfolio. No book has ever been written that discusses asset allocation in this light. * Provides insights from a top-ranked investment consultant using strategies from the industry's brightest minds * Proposes a balanced asset allocation that can achieve stable returns through various economic climates * Introduces sophisticated concepts in very simple terms For those who want to better manage their investment portfolio and seek a more advanced approach to building a balanced portfolio, Balanced Asset Allocation: How to Profit in Any Economic Climate provides an in-depth treatment of the topic that can be put to use immediately.

Leseprobe

Table of Contents

Title Page

Copyright

Foreword

Acknowledgments

About the Author

Introduction

Chapter 1: The Economic Machine: Why Being Balanced Is So Important Today

How the Economy Functions

The Short-Term Business Cycle

The Long-Term Debt Cycle

The Importance of Balance Always, but Particularly Today

Summary

Chapter 2: Your Portfolio is Not Well Balanced

What Is Good Balance?

The Conventional Portfolio Is Not Balanced

Why Is It Not Balanced?

The Flaw in Conventional Thinking

A New Lens

Summary

Chapter 3: The Fundamental Drivers of Asset Class Returns

Breaking Down Returns into Cash Plus Excess Return

The Return of Cash

Excess Returns above Cash

Putting It All Together

Summary

Chapter 4: Viewing Stocks through a Balanced Portfolio Lens

Introduction

The Conventional View: Why Investors Own a Lot of Stocks

The Balanced Portfolio View: How to Think About Equities

Summary

Chapter 5: The High Value of Low-Yielding Treasuries within the Balanced Portfolio Framework

Introduction

The Conventional Perspective

Considering Treasuries through a Balanced Portfolio Perspective

The Role of Treasuries in the Balanced Portfolio

Summary

Chapter 6: Why TIPS Are Critical to Maintaining Balance (Despite Their Low Yield)

What Are TIPS and How Do They Work?

The Conventional View That the Yield of TIPS Is Too Low and Why It's Flawed

TIPS Viewed Through a Balanced Perspective

The Crucial Role of TIPS in the Balanced Portfolio

Summary

Chapter 7: Owning Commodities in a Balanced Portfolio

What Are Commodities Investments?

The Conventional View of Commodities

Considering Commodities through a Balanced Portfolio Perspective

The Role of Commodities in a Balanced Portfolio

Summary

Chapter 8: Even More Balance: Introduction to Other Asset Classes

How to Deconstruct Other Asset Classes Using the Balanced Framework

Additional Asset Classes

Summary

Chapter 9: How to Build a Balanced Portfolio: Conceptual Framework

Introduction: Two Simple Questions

Question One: Which Asset Classes?

Question Two: How Do I Weight the Asset Classes?

Summary

Chapter 10: How to Build a Balanced Portfolio: The Step-by-Step Process

The Logical Sequence behind Efficiently Weighting Asset Classes

Analyzing 60/40 through the Same Lens

Summary

Chapter 11: The Balanced Portfolio: Historical Returns

The Balanced Portfolio Has Achieved Steady Long-Term Returns

The Balanced Portfolio Has Not Underperformed for Extended Periods

The Balanced Portfolio Has Had Limited Major Drawdowns

Summary

Chapter 12: Implementation Strategies: Putting Theory into Practice

The Balanced Portfolio as the Efficient Starting Point

Implementing the Balanced Portfolio

Trying to Improve upon the Balanced Portfolio

Other Implementation Considerations

Summary

Chapter 13: Conclusion

About the Website

Index

End User License Agreement

Pages

ix

x

xi

xii

xiii

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

19

20

21

22

23

24

25

26

27

29

30

31

32

33

34

35

36

37

38

39

40

41

42

43

44

45

46

47

48

49

50

51

52

53

54

55

56

57

58

59

60

61

62

63

64

65

66

67

69

70

71

72

73

74

75

76

77

78

79

80

81

82

83

84

85

86

87

89

90

91

92

93

94

95

96

97

98

99

101

102

103

104

105

106

107

108

109

110

111

112

113

115

116

117

118

119

120

121

122

123

124

125

126

127

128

129

130

131

132

133

134

135

136

137

138

139

140

141

143

144

145

146

147

148

149

150

151

152

153

154

155

156

157

158

159

160

161

162

163

164

165

166

167

168

169

170

171

172

173

174

175

176

177

178

179

181

182

183

184

185

186

187

188

189

190

191

192

193

195

197

199

200

201

202

203

204

205

206

207

208

209

Guide

Cover

Table of Contents

Foreword

Begin Reading

List of Illustrations

Figure 1.1

Figure 1.2

Figure 1.3

Figure 1.4

Figure 1.5

Figure 2.1

Figure 3.1

Figure 3.2a

Figure 3.2b

Figure 3.2c

Figure 3.2d

Figure 3.3

Figure 3.4

Figure 4.1

Figure 4.2

Figure 4.3

Figure 5.1

Figure 5.2

Figure 5.3

Figure 6.1

Figure 6.2

Figure 7.1

Figure 7.2

Figure 9.1

Figure 9.2

Figure 9.3

Figure 9.4

Figure 9.5

Figure 10.1

Figure 10.2

Figure 10.3

Figure 11.1

Figure 11.2

List of Tables

Table 2.1

Table 2.2

Table 2.3

Table 3.1

Table 4.1

Table 4.2

Table 4.3

Table 4.4

Table 4.5

Table 5.1

Table 5.2

Table 5.3

Table 6.1

Table 7.1

Table 7.2

Table 7.3

Table 8.1

Table 8.2

Table 8.3

Table 8.4

Table 9.1

Table 9.2

Table 10.1

Table 10.2

Table 10.3

Table 10.4

Table 10.5

Table 10.6

Table 11.1

Table 11.2

Table 11.3

Table 11.4

Table 11.5

Table 11.6

Table 11.7

Table 11.8

Table 11.9

Table 11.10

Additional Praise for Balanced Asset Allocation: How to Profit in Any Economic Climate

“If you have been interested in understanding how balanced risk asset allocation works, you will want to pick up this clearly written and informative book.”

—Dr. Vineer Bhansali, Managing Director, Portfolio Manager and head of Quantitative Investment Portfolios, PIMCO, and author of Tail Risk Hedging as well as three other financial books

“Alex Shahidi has written a book which, while easy enough for the general investor, offers some deep insights which too many professional investors overlook. Stocks and bonds do not comprise a diversified portfolio; inflation can savage both. What we would call a “third pillar,” a diversifying bulwark against inflation, is a necessary part of any sensible portfolio, especially in today's low-yield environment. Historical returns, risks, correlations, and quantitative tools for manipulating these same data, offer a very poor guide for the future. Past is not prologue.”

—Rob Arnott, Chairman, Research Affiliates

“Alex is a humble, intelligent, thoughtful and passionate investor advocate.”

—Fran Kinniry, CFA, Principal, Senior Investment Strategist, Vanguard

The Wiley Finance series contains books written specifically for finance and investment professionals as well as sophisticated individual investors and their financial advisors. Book topics range from portfolio management to e-commerce, risk management, financial engineering, valuation and financial instrument analysis, as well as much more. For a list of available titles, visit our Web site at www.WileyFinance.com.

Founded in 1807, JohnWiley & Sons is the oldest independent publishing company in the United States. With offices in North America, Europe, Australia, and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers' professional and personal knowledge and understanding.

Balanced Asset Allocation

How to Profit in Any Economic Climate

ALEX SHAHIDI

Cover image: Wiley

Cover design: © iStockphoto.com/Sergey Nivens

Copyright © 2015 by Alex Shahidi. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, [phone], fax [phone], or on the Web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, [phone], fax [phone], or online at http://www.wiley.com/go/permissions.

Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages.

For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at [phone], outside the United States at [phone] or fax [phone].

Wiley publishes in a variety of print and electronic formats and by print-on-demand. Some material included with standard print versions of this book may not be included in e-books or in print-on-demand. If this book refers to media such as a CD or DVD that is not included in the version you purchased, you may download this material at http://booksupport.wiley.com. For more information about Wiley products, visit www.wiley.com.

Library of Congress Cataloging-in-Publication Data

Shahidi, Alex.

Balanced asset allocation : how to profit in any economic climate / Alex Shahidi ; [foreword by] Ray Dalio.

pages cm. – (Wiley finance)

ISBN 978-1-118-71194-1 (hardback) –ISBN 978-1-118-71217-7 (ePDF) –ISBN 978-1-118-71202-3 (ePub)

1. Finance, Personal. 2. Investments. 3. Portfolio management. I. Title.

HG179.S42577 2014

332.6–dc23

2014029359

Foreword

Let's face it—everyone needs a catalyst now and then. For me, this book has been a wake-up call; it has heightened my awareness of the risks in the portfolios I manage, and reminded me that managing money is as much art as it is science. Reading Balanced Asset Allocation has both reinvigorated my perspective related to constructing portfolios, but also given me valuable insights into how the portfolios could react under different economic conditions. Balancing risks and diversifying is what my job is all about. As an institutional investor, I have put the concepts of this book to work in the portfolios I manage. But as the saying goes, the cobbler's children have poor shoes, and I need to do a better job in my personal portfolios.

By explaining how to balance the risks in a portfolio, Alex has written a book that is completely accessible and useful across a wide spectrum of investors. Both the institutional investor managing billions and the average investor saving for retirement over a long time horizon can benefit. You don't need a lot of math skill to implement a balanced portfolio. The recipe is right here in the book. Alex does a wonderful job explaining why the economic machine works the way it does. You don't have to know the volatility of the stock market or the bond market, although the book spends time showing the reader how the numbers work if they are so inclined. The problem with the way we currently invest our portfolios is that they are too dependent on stock market risk. This book shows us a different path. We can construct portfolios with less stock market risk and over time, be fairly confident of achieving similar returns with fewer ups and downs.

What I like about the risk parity concept, pioneered by Bridgewater Associates, is that it explicitly addresses the real world economic events that impact our portfolios, and gives us options when traditional diversification efforts may not always work. The economic machine that produces rising and falling growth and rising and falling inflation, are the big four scenarios that our portfolios should be built to withstand. By balancing risks to these four economic scenarios and rebalancing as necessary, we don't have to worry so much about which stocks are correlated and which bonds are correlated. Correlation is one of the most difficult statistics to rely upon—especially in times of market stress. A balanced portfolio is a different and vitally important way to look at investing. Reading this book will open your eyes to a new perspective. I found it to be a useful and enjoyable read.

—Bill LeeCIO, Kaiser Permanente

Acknowledgments

I wrote this book with the intention of sharing core investment concepts that I thought might be informative for the majority of investors. My target audience was anyone interested in a thoughtful analysis of asset allocation. This applies to the entire spectrum, from novice to expert. Consequently, an indispensable part of the process was to seek honest feedback from a wide range of people.

The first thank-you goes to my friends at Bridgewater, the organization that pioneered many of the core concepts presented in this book. Ray Dalio, Seth Birnbaum, David Gordon, and Parag Shah were invaluable supporters. I am grateful to each of them for introducing me to these ideas and providing essential feedback. This group of special individuals ultimately inspired me to accept the challenge of writing this book and publicly sharing these important concepts.

I am grateful to Bill Lee, a true expert in the balanced portfolio concepts, for writing the foreword and taking the time to discuss these ideas with me. We share a similar passion for investing, and I am so fortunate to have met him through this process.

Charles de Vaulx, one of the most successful investors in the world, has expressed particular interest in these topics. He and I have spent countless hours debating the merits and potential flaws of the approach. He offers a unique assessment because of his financial expertise, and perhaps even more importantly, his intellectually curious and naturally skeptical nature.

Sam Lee from Morningstar offered suggestions that incorporated his experience with many of the concepts presented here. I am appreciative that he took the effort to share detailed, thoughtful comments that materially enhanced the final manuscript.

I would also like to acknowledge Fran Kinniry (Vanguard), Rob Arnott (Research Affiliates), and Dr. Vineer Bhansali (PIMCO), three investment industry giants, for reading through the manuscript and taking the time to provide insightful input.

Other financial experts, who I also consider good friends, were kind enough to dive into the manuscript and provide an indispensable peer review. David Hou, Ben Inker, Wendy Malaspina, Nick Nanda, Larry Kim, and Ron Kutak enthusiastically pored over the manuscript and gave advice that made the final book a clearer communication of the core concepts. Peter Joers, a founding partner at Greenline Partners and a former senior professional at Bridgewater, took the time to read every word and make valuable suggestions. I must thank Damien Bisserier, my trusted friend and business partner, for all his support and feedback from the very beginning of this prolonged journey until the final review.

I would like to express my gratitude to the many colleagues in the industry who also read the manuscript and offered comments. Each was successful in pointing out ways that I could more effectively convey the message. John Ebey, my longtime friend and mentor, graciously guided me through this book as he has throughout my career. My colleagues of more than a decade, Len Brisco, Sergio Villavicencio, and Michael Tidik, eagerly reviewed what I had written and assisted in making needed improvements. My uncle, Clayton Benner, has a remarkable ability to review all my writings with a fine-tooth comb to uncover and correct oversights. Thank you all.

Above all I wish to recognize my wife of 16 years, Danielle Shahidi, who offered a nonfinancial professional perspective and, most impressively, read the original manuscript multiple times cover to cover. I will forever be thankful for her candid remarks and for helping make the final product so much better than what I had originally put on paper. I must also acknowledge her undying support through this long process, which helped me build momentum at each trough.

Likewise, I appreciate the genuine understanding of my wonderful children, Michael and Bella, on all of those late nights and weekends when I was occupied with this project. Of course, my parents, without whom no opportunities at all would exist, are owed most of the credit for this work as well as any other contribution that I have made. Without the full backing of my family, there simply would be no book.

Finally, my team at Wiley deserves recognition for their patience, direction, and extraordinary efforts throughout this endeavor. I would like to express my deepest gratitude to Bill Falloon for giving a new author a chance. Meg Freeborn, Helen Cho, and Susan Cerra are extremely talented editors and were an integral part of helping me bring this project to fruition.

It has been a very long road from when I had an idea about this book until the time it was actually completed. I feel so fortunate to have had so much encouragement and help throughout this prolonged process and will remain immeasurably appreciative to everyone involved.

About the Author

Alex Shahidi has over 15 years' experience as an investment consultant. He has worked for one of the largest financial firms in the world his entire career. Alex focuses on advising large pension funds, foundations, endowments, and ultrahigh-net-worth families. He currently advises on over $13 billion in assets, including several portfolios that are in excess of $1 billion. His average client portfolio is over $300 million.

Prior to beginning his career in investments, Alex graduated with honors from University of California, Santa Barbara, with degrees in business economics and law. He earned his JD from the University of California, Hastings Law School, and is a licensed attorney in California.

Alex is a Chartered Financial Analyst (CFA) Charterholder, Certified Investment Management Analyst (CIMA), and a Certified Financial Planner (CFP). Alex was designated one of the 250 best financial advisors in America by Worth magazine in 2008. He was also ranked as one of the top 40 advisors in the country under the age of 40 by On Wall Street Magazine in 2008, 2009, and 2010. Barron's, a Dow Jones publication, designated him one of the top 1,000 financial advisors in America in 2010, 2011, 2012, and 2013. In 2014, Barron's listed him among the top 1,200 financial advisors in the country.

Alex has published articles on asset allocation and long-term equity market cycles in the Investments and Wealth Monitor, a national publication offered by the Investment Management Consultants Association (IMCA). Alex has also been published by Advisor Perspectives, a leading publisher for financial professionals. His piece on building balanced portfolios, which was the basis for this book, was recognized with the IMCA 2012 Stephen L. Kessler Writing Award. The article was also recognized by the Wall Street Journal, Market Watch, Moneynews, Fidelity Investments, and Wall Street Daily.

Introduction

Sitting in my seat as an investment consultant to institutional investors, I get to meet the best investment managers in the world and glean from them the best concepts. The purpose of this book is to share with you the concepts I consider to be the most important for investors. Most of the concepts in this book were originally conceived of by Ray Dalio and Bridgewater Associates, with whom I have had an invaluable relationship for the past 10 years.

First and foremost, I want to alert you to the most common and costly mistake investors make: having a poor asset allocation. Portfolios are simply not well balanced. In fact, most portfolios are so inadequately balanced that the risks of underperformance are much greater than investors realize. Even the most sophisticated investors are guilty of this oversight, which means that you are most likely exposed as well.

The good news is that this mistake is easy to fix. Big mistake, easy solution—why do we need an entire book to cover this topic? Portfolios have been imbalanced for so long that such a state has become the convention. Poor balance is normal. Consequently, I first want to convince you that your existing portfolio and strategy need fixing. I also should explain why keeping a balanced mix is especially important in the uncertain economic climate of the present decade. Finally, I wish to provide compelling support for the characteristics of a truly balanced portfolio, and most importantly, introduce you to a unique way of thinking about portfolio construction.

The idea here is not to present another purported winning portfolio tactic that happened to work well in the past. This solution is neither a trading strategy nor a super sophisticated way to capture returns that are not available to others. In fact, much of what you are going to read should sound extremely obvious and rational. I strive to appeal to your common sense by explaining the logic from a conceptual, sensible perspective rather than by attempting to convince you of the merits by backfilling historical data. My goal is to engage you in an intellectual exercise to help you see investing from a fresh viewpoint. In the end, you control your destiny and get to decide what makes most sense. I simply want to contribute to the process of helping you make an informed decision.

Throughout this process the greatest challenge will be to help you unlearn what you are confident is true about investing and retrain your mind to think in a way that others simply don't. This renewed perspective will ultimately enable you to make your own decisions about the most logical thought process for developing a balanced portfolio. My responsibility is to help you make an informed decision. Your responsibility is to approach what you are about to read with a blank slate and an objective mind-set. In other words, forget all your assumptions about investing and let us start from the very beginning.

What is the main objective of building a portfolio? The goal is to try to make money in the markets. More specifically, you want to achieve a good rate of return with as little risk of loss as possible. Everyone knows that the markets go up and down; you just don't want to take a big hit. There are essentially only two ways to make money in the markets. You can trade investments (repeatedly trying to buy low and sell high) or you can simply hold investments (buying and holding for the long run). The first approach is risky because you might guess wrong and buy too high or sell too low. The second also has downside because you may choose to invest in the wrong markets at the wrong time. Trading securities is a zero sum game because for every winner there has to be a loser, since the market as a whole is made up of all the buyers and sellers. Moreover, with trading, time is not on your side. You can trade for a long period of time and earn nothing (or less than nothing after fees, taxes, and headaches). Holding markets, on the other hand, is not a zero sum game and time is your friend. You have a high likelihood of success if you wait long enough, particularly if you are invested in a well-balanced portfolio. Most importantly, holding markets is far easier to do and anyone can be successful doing it. For this reason, the focus of this book is efficient asset allocation.

What makes picking the correct allocation an onerous task is the fact that guessing what will happen next in the market is inherently difficult, if not impossible. This is particularly true when you consider that even if you think you know for a fact what the future economic environment holds (which you never do, regardless of what you may think), it does not necessarily mean that you will profit from this prescience. Markets are discounting machines. Current prices reflect expectations of the future. Thus, you must not only accurately guess what the future holds, but your guess must be different from the majority view (which set the price in the first place). In other words, be very careful about being too confident about your ability to consistently pick tops and bottoms in markets. Very few market participants have demonstrated success doing so, and even those who have cannot easily prove that their success is due more to skill than luck.

One of the key messages in this book is the notion that you should have greater confidence in the benefits of diversification than in your investment convictions. Even if you strongly believe that you know what the future holds, you should always trust that a well-diversified portfolio will provide greater benefits over time. In fact, the most dangerous scenario is when you are highly confident of future events that never transpire. The greatest losses generally occur not only when they are least expected, but when investors are most confident that the catastrophic loss is a nearly impossible outcome. For it is during these periods that investors are most apt to maximize their bets.

The answer, then, is to develop a truly balanced portfolio. A balanced asset allocation can help you profit during various economic environments and is not dependent on successful forecasting of future conditions. As you read this book, my hope is that you will better appreciate the appropriate context in which to analyze portfolios. You will gain a viewpoint that will make it obvious that the approach taken by most (likely including you) completely misses the mark and exposes portfolios to major, unanticipated risks. You will learn how to effectively construct a well-balanced portfolio that is less vulnerable to economic shocks. And best of all, the concepts that I will share are extremely simple, intuitive, and easy to implement. Although the logical sequence may make sense to you, the makeup of the truly balanced portfolio will undoubtedly surprise you. The simplicity of the thought process and the asset allocation outcome is the most compelling feature. As is often the case, simple is more sophisticated.

This book is divided into the following sections:

Chapter 1 will establish the foundation for understanding how the economic machine functions. Viewing today's unique climate within this context will explain why maintaining a well-balanced portfolio is even more important than usual.

Chapter 2 will demonstrate just how rare it is to find true balance in portfolios despite the great need. Many think their portfolios are well balanced and will be surprised to discover the reality of significant imbalance in the conventional asset allocation.

In Chapter 3 I will explain what fundamentally drives asset class returns. The insights shared in this chapter will set the stage for how you should think about asset classes and balanced portfolio construction.

Chapters 4–8 will analyze the major asset classes through the newly introduced balanced portfolio lens. By viewing stocks, bonds, commodities, and other market segments through this new perspective, you will likely reach a different, unconventional conclusion about the role of each asset class within the context of a truly balanced portfolio.

Chapters 9 and 10 will help you apply the lessons in practice. Specific steps to build a balanced portfolio will be described. The rationale for a sample balanced portfolio, as listed below, will be provided.

The Balanced Portfolio

20% Equities

20% Commodities

30% Long-Term Treasuries

30% Long-Term TIPS

Chapter 11 will demonstrate the benefits of a truly balanced portfolio by providing long-term historical returns to support the core concepts.

To round out the discussion, Chapter 12 will provide implementation strategies to help you put into practice the concepts you learn in this book.

Chapter 1The Economic Machine

Bridgewater Associates, the largest and most successful hedge fund manager in the world, pioneered most of the concepts that I will present in this book more than 20 years ago. Bridgewater is at the forefront of economic and investment research and has been refining and testing its concepts over the past two decades. The company has a great understanding of what drives economic shifts and how those shifts affect asset class returns. The first chapter is effectively my summary of its unique template for understanding how the economic machine functions. Bridgewater has released a short animated video that explains their template and related research at www.economicprinciples.org, and I encourage you to visit the site. The core principles presented throughout the rest of the book were also developed by this remarkable organization over the past couple of decades. I know of no one in the industry that has a better command of this subject.

In order to fully recognize today's unique economic climate, you first need to better comprehend how the economic machine generally functions. The goal of this first chapter is to arm you with a command of the basic inner workings of this machine to enable a deeper appreciation of why this topic of building a balanced portfolio is so timely. Insight into the economic machine will also lay the required foundation for an improved understanding of the key drivers of asset class returns. I will refer back to this opening chapter throughout the book because it introduces core, fundamental concepts that impact markets, and therefore portfolio returns.

How the Economy Functions

Constructing the appropriate asset allocation is always a challenge, but it is particularly difficult in the current economic environment. The reason is simple: The United States and many other developed world economies are fighting through a deleveraging process that is likely to last for a decade or longer. Deleveraging is a fancy term for debt reduction or lowering leverage. When the amount of debt in any economy gets too high relative to the ability to pay it back, then the debt burden must be reduced. But what does this really mean and why is it so important? To effectively answer this central question, I will start at the most basic level.

The economy functions like a machine. Money flows through the machine from buyers to sellers. Buyers exchange their money for goods, services, and financial assets. This is what money is used for, and it is only worth something because you can exchange it for goods, services, and financial assets. Sellers sell these items because they want money. Buyers buy these things to fill a need. Goods and services help support their lifestyles while financial assets are used to preserve and increase wealth over time. An economy is simply the sum of billions of transactions between buyers and sellers. An economy grows when there are a lot of such transactions and it stagnates when the flow of money slows. At a fundamental level it really is that simple.

The Short-Term Business Cycle

The ability to borrow money slightly complicates the mechanics of the machine. If borrowing were not allowed in the system, then buyers would only buy what they could afford to pay using existing money. There would be no deleveraging because leverage would not exist. The economy could be more stable, although it may operate below its potential because capital would not flow as efficiently. With borrowing, a buyer is able to spend tomorrow's income today. If I want to buy a good, service, or financial asset and do not wish to (or cannot) pay with cash, then I can simply promise to pay for it in the future. I have created credit. This is what typically happens when you buy a house, swipe your credit card at the grocery store, or promise to pay your friend back if he buys you lunch. In each case you have created credit. Your balance sheet has been leveraged, and the amount of debt you owe and your debt service have just increased. A simple way to summarize these concepts is to say spending must be financed either from money or credit (so spending = money + credit).

With leverage an economy can grow more than it would otherwise because buyers can use both money and credit to make purchases. If they don't have enough money, they can use credit to buy what they couldn't afford to pay for with current funds. Because your spending is someone else's income, when you buy more using credit, then others earn more than they would otherwise. Then their increased earnings lead to increased spending and so on. The economy grows because it is simply the sum of all the transactions. Figure 1.1 displays this general cycle.

Figure 1.1 Basic Cycle of Economic Growth

The central bank plays a key role in managing this process. The Federal Reserve (known as the Fed) is the central bank of the United States; other major economies around the globe have their own central banks. The objective of the central bank is to try to smooth out fluctuations in the economy. Fluctuations can be measured in terms of both economic growth and price stability or inflation. The Fed does not want the economy to weaken too much because reduced spending feeds into falling incomes, which begets more spending cuts. The Fed also does not want prices to rise too quickly. If there is too much money chasing too few goods, services, and financial assets, then upward pressure is exerted on prices, which can be harmful to an economy if it goes too far. In short, the Fed seeks the goldilocks economy (moderate growth and low inflation—not too hot, not too cold, just right).

How does the Fed try to maintain economic and price stability? The main policy tool the Fed uses is to control short-term interest rates. Whenever the economy is weakening or inflation is too low, the Fed can stimulate more borrowing by lowering short-term interest rates. When inflation is too high or the economy is growing faster than desired, then the Fed can raise interest rates to curtail borrowing. Recall that total spending must be financed by money or credit. The supply of money is relatively fixed most of the time. However, the supply of credit constantly changes and is largely influenced by interest rates. All else being equal, the lower the interest rate you are being charged the more money you would borrow and the higher the rate the less you would borrow. When credit is cheaper, the growth of credit typically increases and vice versa. When the Fed wants to stimulate more borrowing to support the economy or to increase inflation, it lowers rates to a level that encourages sufficient borrowing to achieve the desired outcome.

This interrelationship is why we have the familiar business cycle: The economy weakens, the Fed lowers rates, credit expands, spending picks up, and the economy improves. Eventually inflation pressures may build and the cycle reverses: The Fed raises rates, credit contracts, spending declines, the economy weakens, and inflation subsides. These cycles typically last three to seven years and are easily recognizable because of both their frequency and the relatively short time frame between inflection points. Investors have seen these cycles so many times that they have a good understanding of the pattern and how they work. Few are surprised when the cycle turns because they have firsthand experience with this dynamic. Figure 1.2 displays the normal business cycle.

Figure 1.2 The Normal Business Cycle

Most investors, economists, and even lay people are probably familiar with the above-described parts of the economic machine. What follows next is much less understood, and in fact the concepts that will be presented have been completely missed by many economists and certainly by most investors.

The Long-Term Debt Cycle

There is another cycle that is working in the background of the economic machine just described. Most people are completely unaware of its existence because the cycle only hits its inflection point once or twice in a lifetime. By comparison, the business cycle covered earlier turns every three to seven years, on average. This longer-term cycle, often referred to as the long-term debt cycle, may last many decades before it changes direction. The only time it really matters and is worth paying attention to is near those critical inflection points. It is at those rare moments that no one can continue to ignore the powerful forces that ensue.

As covered above, the short-term business cycle exists because the Fed moves short-term interest rates in response to economic conditions. Over time, whenever the Fed lowers rates, increased borrowing adds to debt levels on balance sheets. Debt levels can continue to rise for a long period of time due to the self-reinforcing dynamic that is involved. The dynamic is self-reinforcing because the creditworthiness of a borrower is based largely on the value of his assets and income. Lenders want to make sure that they can be paid back. The higher the borrower's income and collateral, the higher are the odds of repayment. Going back to economic machine basics, when I borrow and spend, then the economy grows because that spending is someone else's income. In sum, when we borrow to spend, our collective incomes rise. Rising incomes further support debt accumulation. Additionally, the value of our assets increases through this leveraging phase of the cycle because we have a greater ability to spend on assets such as stocks and real estate. The boosted spending on assets pushes their prices higher. The cycle is virtuous in nature: More borrowing leads to increased spending, which improves incomes and asset values, which are the key factors used by lenders to assess creditworthiness of borrowers.

Therefore, the short-term business cycle (three- to seven-year boom-bust economic cycles) operates within this longer-term debt cycle (50- to 75-year leveraging-deleveraging cycles). Each time the Fed lowers rates, the amount of debt in the economy increases; when it raises rates, debt growth slows. The level of debt generally does not materially decline during this phase; the growth of the debt merely pauses temporarily. Then the economy requires additional stimulus and debt levels go up once again. This continues until the total amount of debt in the system is too high and can no longer rise. In other words, balance sheets go through a long period of leveraging as they are constantly supported by higher asset values and incomes. This cannot continue forever as the cycle ends when debt limits are reached. We collectively hit our debt ceiling when we can no longer make interest payments on our debt and our assets have become impaired. At that point, we are no longer creditworthy and have difficulty refinancing our debt and increasing our borrowing. Our aggregate balance sheet is too highly levered relative to our assets and income and must be repaired over time. The typical dynamic is illustrated in Figure 1.3.

Figure 1.3 The Virtuous Cycle of Debt Growth

The Deleveraging Process

The virtuous cycle continues until the system collapses under its own weight. Bad loans are made to bad borrowers; defaults pick up and the cycle finally turns. The Fed, in its normal response to weakening growth, predictably lowers interest rates to stimulate more borrowing. This time it does not work. More borrowing is not possible simply because the borrowers are no longer creditworthy and the lenders, after recently being burned with massive defaults, have stopped lending. Rates fall to zero and the business cycle unexpectedly does not revert this time. The market is stunned and the economic machine literally stalls. Since total spending must come from money plus credit, and credit growth has reversed, total spending falls precipitously. This surprise creates fear, and those with money significantly cut their spending, which further exacerbates the problem. The cycle reverses after decades of going in one direction and the deleveraging process begins. It's akin to a speeding car on a crowded freeway suddenly shifting into reverse. Horrific accidents are inevitable. This is exactly what happened to the U.S. economic machine in 2008, and it is the exact same experience that captured the nation in 1929 at the onset of the Great Depression. These periods are normal responses, but they just don't repeat frequently enough for people to fully recognize and understand them.

The deleveraging process is just that: a process. It is inescapable and will repeat over and over again. The process is a largely unavoidable part of the economic machine because it is fundamental to how the machine is built. A credit-based economic system like ours is dependent on increased borrowing to finance spending, and there is great incentive to keep the cycle going as long as possible. It works well for a long time until the debt cycle reverses. When the cycle changes course, the process is self-reinforcing, just as it was during the upswing. In contrast, the normal business cycle is self-correcting. When the economy is too strong, tight policy causes it to slow, and when it is too weak, loose policy promotes an improvement. The long-term debt cycle feeds off of itself, however. I have already covered how this is the case on the way up. The opposite set of conditions drives the self-reinforcing process on the way down. I can't borrow any more so I spend less than I spent before. My reduced spending brings down your income so you spend less and that in turn negatively impacts someone else's income. The reduced overall spending and selling of assets to pay down debt also drives down asset prices, which hurts the value of borrowers' collateral, further degrading their ability to borrow. I spend less because I am earning less but also because I recognize that I have too much debt and want to take some of my income and pay down debt to gradually repair my balance sheet. This self-feeding dynamic causes a severe economic contraction in the beginning stages of the deleveraging process. The weak economic climate exacerbates conditions and confidence and can quickly lead to an economic depression. This is why a depression is not simply another variant of the normal business cycle recession. It is caused by a reversal of the debt cycle, not by the Fed tightening interest rates too much, which is precisely what causes normal recessions. Most people fail to appreciate this critical distinction because of a general misunderstanding of the mechanics of the economic machine and a lack of appreciation of the difference between the short-term business cycle and the long-term debt cycle.

How does all this relate to where we are in the cycle currently? The simplest way to measure the total debt to income ratio of a country is by taking all the debt in the economy and dividing it by the country's income, called the gross domestic product (GDP). This is a very basic measure of how indebted a nation is. You would follow the same logic to assess whether you personally have too much debt relative to your income. The country as a whole is merely a sum of its parts and is no different.

Figure 1.4 illustrates the debt level of the United States over the past century. The last deleveraging process in the United States took about 20 years to run its course. The country reached its debt ceiling in 1929 (after the Roaring Twenties) and deleveraged until around 1950. It subsequently enjoyed the tailwinds of the leveraging cycle from the early 1950s until 2008 and is likely now once again saddled with the headwinds of the deleveraging process, and will likely be for a decade or two. The ratio of debt to GDP in 1929 was about 175 percent (it jumped to 250 percent during the Great Depression because GDP fell faster than total debt). In 2008 the ratio hit 350 percent, twice the level that caused the Great Depression! It took about 60 years of leveraging to achieve such a high ratio. Last time it took 20 years to bring the debt-to-GDP ratio back to a normal level; how long will it take this time, given the more extreme starting point? It certainly will not happen in a few years.

Figure 1.4 U.S. Total Debt as a Percentage of GDP (1900–2013)

Source: Bridgewater Associates.

In most cases throughout history, economies live through a painful depression during the deleveraging process as the self-reinforcing negative feedback plays out. This process produced Japan's so-called lost decade, which began in the early 1990s. Europe is suffering through the same fate today, and even countries like Australia and Canada remain vulnerable to that critical inflection point, given their high debt levels.

Given this discouraging backdrop, why has the U.S. economy not fallen into a depression during the present deleveraging process? What makes the current period seem not as bad as the Great Depression or other similar depressionary environments? Deleveraging produces a persistent headwind for the economic machine and prevents it from functioning in its normal fashion. This force is exceptionally powerful and if left alone to run its course, extreme economic and social hardship is a near certainty