Personal Finance

Asset Allocation is the process of dividing investments among different kinds of asset classes (such as stocks, bonds, cash, real estate, commodities, etc.) to try to meet specific financial goals.  Brinson, Hood & Beebower research of 1986 proved that asset allocation is the single most important decision that an investor makes.  Over 90% of portfolio performance is explained by the asset allocation decision.

 Traditional asset allocation models do not work for real people because their portfolios are much different from institutional portfolios.  Over 80% of all American households have a net worth that is less than $250,000 which includes the value of their home. Some of the big differences between institutional portfolios and those of most individuals include single vs. multiple goals, single vs. multiple time horizons, simple vs. complex tax treatment, professional vs. amateur investment management.

These differences led the founder of the Cambridge system to create a Functional Asset Allocation (FAA) model for individuals.  FAA illustrates how individuals build wealth as measured by Net Worth.

1)      Functional Asset Allocation – all your assets, including your home and personal belongings.

2)      Traditional (institutional) Asset Allocation – only financial assets, including checking accounts, savings, emergency funds, etc.

Using Functional Asset Allocation, your assets should be distributed across three asset categories: Interest Earning, Equities, and Real Estate. Generally, you want to have 1/3 (range of 25-40%) of your net worth in each of the three major asset classes.  Each of the major asset classes serves practical functions in wealth accumulation and risk management.

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