Excerpted from Chapter 7 of The Great Reflation.

Reprinted by permission of the publisher, John Wiley & Sons, Inc., The Great Reflation by J. Anthony Boeckh. Copyright (c) 2010 by John Wiley & Sons, Inc. All rights reserved.

By J. Anthony Boeckh

Asset allocation is simply an attempt to bring a rational process to the ever-present problem of what investors should do with their money to achieve their goals. Investors have three main decision points: which assets to hold, in what proportions, and when to change those proportions. Investors need to have realistic expectations, but very few do. Most people want high returns and no risk but that is not how the world works. Risk and return go up and down together. There are proven techniques that will maximize expected return for a given risk, or minimize risk for a given expected return, and that is how investors should think about investing. The concept is straightforward, but the application and execution require some effort. In Part II of the book, we try to simplify the process as much as possible so as to make it useful for most investors.

Sophisticated institutions use complex, computer-driven models, but it remains far from clear that their results are better than those achieved using a simplified approach. Lack of discipline and a strong tendency of most people to feel more comfortable running with the herd are the real enemies of good investment performance, not the lack of complex models.

The starting point for all investors is to establish goals. For individuals this is a subjective process and should be done with family members and trusted advisers. Institutional investors have boards of trustees and directors whose job is to set goals. Second, investors need to decide which asset classes they should focus on and to understand the risk and returns they can expect from each. Third, they need to understand the correlations (the degree to which they move together) among the different asset classes they hold so they can benefit from the risk-reducing potential of diversification (i.e., not putting all your eggs in one basket). Fourth, investors must be aware of the characteristics of a good portfolio. These are derived from the individual holdings in the portfolio and how they interact with each other over time in the real world of market fluctuations, economic cycles, and inflation.

Each investor has needs that are unique to some extent. One size does not fit all when it comes to portfolios. However, there are some general points that apply universally. A good portfolio will have sufficient liquidity to take care of cash needs and the absorption of capital losses, and also will take into account the time horizon and risk tolerance of the investor. The portfolio will have sufficient liquid reserves and cash flow, if possible, to avoid the need for selling securities at an inopportune time. The less cash flow that investors have, the more liquidity they should hold. All portfolios got stress-tested in the recent crash, and far too many people found they had insufficient liquidity and cash flow and had to dump securities at a time of general panic. That is a position in which you should never find yourself. The smart ones had liquidity and bought in the panic at fire sale prices.

The portfolio must be able to protect against general price inflation (loss of purchasing power) and currency depreciation. It must be diversified across and within asset classes to reduce risk. For example, you don't want all your money in stocks. And the position you do have in stocks should be diversified by industry, size, and geography. The assets that are expected to produce either income or growth should be purchased and held only when they provide good value. Otherwise, there is too high an exposure to capital loss or income disappointment.

For most people, in normal times, three legs to the portfolio stool will do the job well--stocks, bonds, and short-term liquid assets. These can be held directly or in the form of mutual funds or other types of pooled funds.2 With a judicious mix of these assets, investors can get income, growth, and liquidity. They are overwhelmingly the most important financial assets for most people, and that should be their primary focus. The problem currently is that we are not in normal times. Safe liquid assets yield almost nothing, and a portfolio of stocks, bonds, and short-term liquid assets does not provide proper protection against a decline in the purchasing power of money. As a result, many investors are once again reducing liquidity and speculating in perceived inflation hedges like gold and commodities. We will return to this theme later.

Owning a quality house or other form of property can provide a fourth leg to the portfolio stool and make it more solid because it will provide protection against inflation in the long run. A house, purchased at a sound valuation, properly financed over a reasonable term, and providing principal and interest payments over the life of the mortgage, creates forced savings. By retirement, the mortgage should be paid off (assuming that the temptation to borrow with home equity loans against rising values is avoided). In such a case, the homeowner would have a large, inflation-protected asset and be debt free. This would provide a wonderful cushion in old age with no mortgage servicing costs at a time of reduced cash flow.

There are other asset classes definitely worth consideration for portfolios that can provide a more optimal mix to attain risk and return objectives. These are discussed in the following chapters.

About the author:J. ANTHONY (Tony) BOECKH is President of Boeckh Investments Inc., a family office and private investment firm specializing in small public companies. From 1968 until 2002, he was Chairman, and Editor-in-Chief of BCA Publications, known for the Bank Credit Analyst and related international investment publications. He has lectured at economic, financial and investment seminars and conferences in various international centers in North America, Asia and Europe. He co-authored The Stock Market and Inflation published by Dow Jones-Irwin in 1982. Mr. Boeckh is also a founding trustee of the Fraser Institute (an economic "think tank" dedicated to free market principles).