Optimal Asset Allocation

Last Saturday (8/26/2006), three of us (Brian Zeng, Max Song and myself) organized by Olina Peng were giving a seminar about investment strategies. One of the questions asked about optimal asset allocation. I tried to answer the question with the following thinking.

I divided the world into five categories - Real assets (wealth created up to date and not yet decayed away), means of production (machines and related software accumulated for productions), natural resources can be developed to feed into the production or direct consumption, Bonds backed by future revenue streams, and the asset-backed bonds. I believe that one should invest in each of the five asset classes to have an optimal risk-adjusted return.

Real assets include real estate, gold and other precious metals, and infrastructure such as hydro power plants, airports, roadways, railroads, and waterways. This is a critical part of the overall wealth created in the past. One class of bonds are related to this class of assets, the asset-backed securities. So naturally one should own both of the real assets and asset-backed securities.

Natural resources and the means of production are closed related to each other. When the production capacity is increased, the need of natural resources such as petroleum, lumber, industrial materials is also increased. So one should invest in both class of assets in order to capture the complete picture of the production process.

Revenue-backed securities are the most prominent class of assets. They are issued by governments (US treasury issued by the US government, municipal bonds issued by state and local governments) and corporations. Since the government bonds and municipal bonds are backed by tax-revenue, so they represent the overall average growth of the country. It should reflect the growth rate of GDP (Gross Domestic Products).

If equal weights are given to the five asset classes, the 20% each should be invested in real assets, asset-backed securities, natural resources, equity, and revenue bonds.