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We use a Functional Asset Allocation (FAA) approach to investing.  We find that each asset category serves an important purpose in people’s lives.  For example, although most money managers recognize real estate as a separate asset class, they do not consider it when constructing an asset allocation model. The value of your personal residence represents more than a straight financial calculation would indicate.  A great deal of your home’s value is in your own enjoyment of it.  The enjoyment can not be accounted for in fancy computer models.  For professional money managers, it does not exist.  It is also usually the largest and most profitable investment a family has.  In our model, it is recognized as the best protection against inflation.

FAA is based on optimizing the way people utilize their assets in a household and on the psychological needs combined with the life goals of real people in a dynamic society.  Interestingly, our experience and comparative analysis have found that FAA provides most of the benefits of diversification offered by modern portfolio theory.  It also yields a better after tax return with less risk for most of the people we work with.

FAA has three asset categories which address specific purposes:

  • Interest Earning = Protection Against Deflation.  The interest earning asset category consists of two broad asset classes:  cash and bonds.  It serves the purpose of capital preservation.   Regardless of what happens in the financial markets and in people’s lives, we want to make sure our clients have adequate cash flow in order to maintain their standard of living for a given period.  Interest earning investments protect you during deflation by proving a reliable cash flow while keeping this portion of your investment portfolio safe.
  • Real Estate = Protection Against Inflation.  The real estate asset category is divided in three asset classes:  personal residence, productive (including real estate investment, real estate investment trusts, and rental property) and nonproductive (such as vacant land, second homes, and passive limited partnerships).  The unique functions of real estate include personal use and enjoyment and the opportunity to leverage your investment by mortgaging the property.  Positive financial leverage through a home mortgage provides Americans with one of the most advantageous after tax investment vehicle in the world.   Real Estate investments offer protection during periods of inflation.  Real Estate is the most inflation sensitive assets out there, although there is wide regional variation in housing appreciation.  Leveraged real estate is the best inflation protection you can have if you have borrowed at a fixed rate of interest.
  • Equities or Ownership in the Great Companies of America and the World = Profits During Prosperity.  Equities are the growth engine of the portfolio but are also subject to the most volatility.  The Equities asset category includes four asset classes:  Domestic equities, international funds and gold bullion (hedge dollar), individual stock holdings (higher volatility), and employer stock.   Most standard asset allocation approaches ignore the reality that company stock plans are the driving force (requiring careful tax management) in the portfolios of many employees.  Reality requires that “Recreational investments” in individual stocks, which involve ad hoc stock picking based on market timing systems and are comparable to gambling, carry a different risk component for small investors because there is not enough money to diversify adequately.  Equities provide growth during periods of prosperity.  They are the engine that has enabled many families to greatly increase their net worth.

The advantage of using the Functional Asset Allocation approach for your investment portfolio is that each asset class performs a discrete function in your portfolio.  This enables you to hedge yourself against the two economic dangers, inflation and deflation, while still enabling you to have a part of your portfolio poised for growth in times of prosperity.  This eliminates the need for market timing.  Firms that sell securities devised the traditional allocation systems used today by most financial advisors.  Because they were devised by securities firms, they ignore important aspects of the portfolios of real people, such as their real estate holdings, complications involving employer stock, leverage, and tax considerations.  These factors are not revenue producers for most financial advisory firms, so they are generally ignored by financial planners who work for financial institutions.

The Analogy of the Farmer  

The most effective analogy we have found to help people understand FAA is to think of your portfolio as if you were a farmer:

  • Your equities are the crops in your field.  This is where you earn your livelihood.  There needs to be some diversification.  You may have corn, or even some cows.   You don’t want to invest in only one crop.  Not only would that increase the likelihood of being wiped out completely should insects or disease attack, but it would not be productive in the long term because consistently planting the same crop would deplete the soil of nutrients necessary to help the crop grow.  Depleted soil leads to a much lower yield.  You also do not want to have too many different kinds of crops in your field because that would make it too difficult to farm efficiently.
  • Real Estate is your garden.  You have a house and a barn, some chickens, and pigs running around, plus cucumbers and tomatoes growing.  You are able to leverage the yield of your garden by using manure from the cows in the field for fertilizer and feeding some of your corn to the pigs.  Your garden protects you against inflation.  If the grocer in town were to raise food prices, you would be able to be self-sufficient by drawing from your garden.  You also have flowers in your garden purely for personal enjoyment.  This is the point:  Your garden is not competing against your crops in the field for yield.  They have two different purposes, two different functions, so don’t compare the two.
  • Interest earning investments can be compared to your pantry.  As a prudent farmer, in good years you take some of your wheat and grind it into flour.  You take some of the milk and churn it into butter and make into cheese.  Some of your beef is butchered and frozen.  You draw from both your crops in the field and the surplus from your garden to fully stock your pantry.  Farming is a volatile business, with many factors beyond your control such as weather, disease and pestilence.  You know you need to be able to sustain yourself through several years of drought, if necessary.  You stock your pantry so you can survive lean years.  Again, the point is that pantry is not competing against your garden or your crops in the field for yield.  It too has a completely different purpose, an independent function.  When it comes to the pantry, safety trumps yield.

 Primary Investment Vehicles

  •      Low expense mutual funds such as Dimensional Fund Advisors (DFA) Institutional mutual funds
  •      Bonds including Treasuaries and Muncipal
  •      CDs
  •      Direct Real Estate Investments


Helpful & Interesting Links 

DFA's Disciplined Approach