Among my many duties as the chief investment strategist for Personal Finance is to manage its model portfolio allocation. To keep it simple, we only use four asset classes: cash, stocks, bonds, and hedges.

At the start of each year, I reset the portfolio allocation based on my perception of relative risk and reward among those four asset classes. In January 2021, I set the allocation at 45% cash, 30% stocks, 10% bonds, and 15% hedges.

At that time, interest rates were artificially low. The Fed was still pursuing its ZIRP (zero interest rate policy) in the aftermath of the coronavirus pandemic to prop up the economy.

Also, it was not clear at that time when the coronavirus pandemic would subside. New variants of the virus were playing havoc with global supply chains, and we did know how effective recently approved vaccines would be.

For that reason, I allocated 45% of the portfolio to cash. That year, the iShares Short Treasury Bond ETF (SHV) returned -0.1%.

I kept 30% in the stock market, which performed well that year. The SPDR S&P 500 ETF Trust (SPY) gained nearly 29% in 2021.

I did not think bonds would do much while the Fed was suppressing interest rates. So, I put only 10% into the Fidelity Investment Grade Bond Fund (FBNDX) which lost less than 1% that year.

I wasn’t sure what would happen with inflation, so I allocated 15% to the Fidelity Global Commodity Stock Fund (FFGCX). It gained 26% that year.

On a weighted average basis, this portfolio returned 12.4% in 2021. I considered that a good result given how much uncertainty there was in the financial markets at that time.

Less Risk, More Return

One year later, I made some changes to the portfolio. I increased hedges to 25% while dropping cash to 25%. I raised stocks to 40% while leaving bonds at 10%.

Inflation was on the rise as evinced by a noticeable uptick in the CPI (consumer price index). I felt that it would not be long before the Fed started raising interest rates to combat rising inflation.

My hunch proved correct. A few months later, the Fed started raising interest rates and bond prices dropped. For all of 2022, FBNDX lost 13%.

The stock market also lost ground that year. The SPY fell by 18% as the stock market tanked during the second half of 2022.

At the same time, commodity prices were rising. For that reason, FFGCX gained 20% as producers of oil, precious metals, and agriculture saw their operating margins expand.

As for our cash position, SHV returned 0.9%. That’s not much, but it’s better than losing a lot of money in the stock and bond markets.

On a weighted average basis, our model portfolio returned -3.28% in 2022. I’d prefer not to have lost any money at all, but compared to the stock and bond markets we did pretty well.

Over those two years our model portfolio returned 8.7% compared to a 5.3 gain in the SPY. That means we outperformed the S&P 500 Index while never having more than 40% of our total portfolio exposed to the stock market.

That two-year period illustrates the fundamental problem with being fully invested in any one asset class. It only takes one down big down year to erase most of your gains.

More Science than Art

The annual process of strategic asset allocation is not the same as market timing. Market timing is short-term in nature and involves only one asset class or security.

Strategic asset allocation is a dynamic process based on the relative value of multiple asset classes. When an asset class appears to be overvalued, money is taken from it to invest in an asset class that is undervalued by comparison.

Of course, there can be no way of knowing how any asset class is going to perform in the future. There are too many unknowns that can quickly reverse the direction of a recent trend.

But there are ways of measuring the relative value of one asset class to another. There are also known relationships between macroeconomic factors such as inflation with asset classes such as hedges and bonds.

Strategic asset allocation is not a perfect science, but it is more science than art. It is used by pension fund managers and other institutional investors to maximize investment returns over the long term while minimizing risk in the near term.

You do not need to know how to do it to use it in your portfolio. There are diversified mutual funds that can do that for you.

However, the upside to strategic asset allocation is also its downside. You will never realize outsized gains due to the diversified nature of the portfolio.

If you only need to generate an average annual return in the mid-single digits, then strategic asset allocation should work well for you. But if you need to do a lot better than that, you will have to focus on a less diversified investment strategy and hope you picked the right one.

Instead of hoping, I suggest going with an investment strategy that has a proven track record of producing consistently high returns, such as the one used by my colleague Dr. Stephen Leeb.

As chief investment strategist of The Complete Investor, Dr. Leeb has produced a special report on how to not only survive, but also thrive during the tectonic shifts facing the financial world. Click here for details.

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