Sunday, 28 March 2010

Asset Allocation and Economic Hedging in Various Economic Environment

Asset Allocation

This is also referred to as economic hedging and can be defined as a conservative method of diversifying assets so they will react different under various economic conditions.

Successful investing can be based on 4 key characteristics as follows:
  • Discipline
  • Patience
  • Historical Prospective
  • Common Sense Strategy
Reasons for using asset allocation:
  • History repeats itself
  • No one can predict the future – not even the experts
  • Comfort in knowing you have not painted yourself in a corner
  • Acts as a hedge against financial risks you cannot control
To protect against risks, the risks must first be identified and then investments set up to diversify around them. Listed below are the main types of economic environments.
  • Hyper Inflation (100%+/year)
  • Double Digit Inflation (10%+/year)
  • High Inflation (5 to 9%/year)
  • Normal Inflation (2 to 4%/year)
  • Recession
  • Depression
Now lets look at a couple examples of how various investment types do in these differing environments.

In a depression we see the following:
  • Stocks go way down (85-90%)
  • Real Estate – Also tends to go down
  • Interest Rates – drops to very low rates
  • Unemployment – this goes way up
  • Property – material things tend to lose value
  • Bonds – These do well, as bonds tend to vary inversely with interest rates.
Recommended investment in a depressed economy then would be high quality, intermediate term (2-4 year), discounted corporate bonds.

On the other hand in a Hyper-Inflation economy the situation would be completely different.
  • Stocks – do well for a while, then collapse
  • Real Estate – depends, because it is often bought with debt
  • Gold – this has done well in keeping its value in hyper-inflation conditions
Of note, the last time the US was in a hyper-inflation economy was during the civil war. However several other countries have been in this situation in recent years.

Now that we know how the environment can affect different investments, let's look at what investments are best for each environment and how to protect your investments in these changing economic times with economic hedging.

Economic Hedging

Following our discussion on asset allocation, below is a list of the best types of investments for each type of environment.

Economic EnvironmentBest Investment
Hyper InflationGold
Double Digit InflationReal Estate
High InflationReal Estate / Stocks
Normal InflationStocks
DepressionHigh Quality Corporate Bonds

How you will allocate your assets will depend on if you are in or near retirement as well as other personal circumstances. Below are two basic allocation structures. You should review your own needs to decide what type of allocation meets your needs best.



(These percentages can be vaired slightly to fit in 2% Gold for better hedging.)

Over the past 30 years, average yields for these types of investments has been about as follows:
InvestmentAvg Yield

For the retired plan then this would have yielded a safe 7.25% annual return. For the aggressive investor it would closer to 8%.


In order to keep the advantage of asset allocation you should rebalance your investments every year. When this is done is not important as long as it is done at least once per year. By taking profits from the investment types that are doing well and putting the money in those that are down, you are buying low and selling high without any emotional input that may cloud your decision. Rebalancing should then be done as follows:
  • Periodically (at least once per year)
  • If there is a major change in your life
  • If there is a major change in the financial market

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