There’s a puzzle of sorts in asset allocation, and it falls under the rubric of uncorrelated returns.  When a new asset class arrives, and it is small and few invest in it — lo, it is uncorrelated!

But then the word spreads, and more investors begin investing in the alternative asset class.  This has two effects:

  1. It drives up the price of the alternative assets, temporarily boosting performance, and
  2. It makes the asset class returns more sensitive to the actions of large institutional investors, such that the correlations rise with stocks and other risk assets.

How an asset is funded matters a great deal as to future price performance.  I often talk about strong hands and weak hands in investing, but I can make it simple:

  • Strong Hands — Well capitalized, little debt, and what debt there is, is long-dated.  Such people can buy assets and ride out storms, not worrying about mark-to-market losses.
  • Weak Hands — Poorly capitalized, much debt, and what debt there is is short-dated.  A storm will capsize them, making them forced sellers of the assets they acquired with debt.

Buffett understands this.  His insurance companies have relatively low underwriting leverage, but they benefit from high allocations to stocks.  He can own stocks because there is a core amount of liabilities that will fund the stocks that he owns.

Think of housing for a moment. Asset prices were highest when the ability to use short-term low-cost financing was abundant. Eventually, there was no demand for housing when prices would lock in losses for buyers who would rent the property out.

If an asset is owned by entities that have weak financing, there is a real risk of loss if the financing can’t be maintained.  You become subject to the credit cycle, which governs much of investing.  Invest when credit spreads are wide; don’t invest when they are narrow.

I know that advice is vague, but that’s a part of the game.  You have to adjust the riskiness of your portfolio to overall conditions, and resist trends, if you want to make money over the long run.

How people and other entities fund the assets that they own has an effect on the future price performance, because it affects how they might buy or sell.

By David Merkel, CFA of alephblog