As an addition to my Optimal Asset Allocation post yesterday, I thought I’d share this graph which helps explain how I view the current investment landscape.
Principle #1: The goal of investment is to beat inflation over the time period which the investment is held. To paraphrase a Warren Buffett article from 2012 -” investing is the transfer to others of purchasing power now with the reasoned expectation of receiving more purchasing power in the future. More succinctly, investing is forgoing consumption now in order to have the ability to consume more at a later date. From this definition there flows an important corollary: The riskiness of an investment should be measured by the probability — the reasoned probability — of that investment causing its owner a loss of purchasing power over his contemplated holding period. Assets can fluctuate greatly in price and not be risky as long as they are reasonably certain to deliver increased purchasing power over their holding period.”
Principle #2: Again to paraphrase Buffett – investors should put more money into their best ideas – those which offer a higher risk-adjusted return. And the corollary to this principle is “Wait for the fat pitch”, ie. be patient, ignore the daily market moves, and then load up when the market offers a bargain.
With these two principles in mind, the graph below presents my projected asset class returns compared against the expected future inflation rate. Then I allocate among assets using 1) the Standard Deviation and Sharpe Ratio of returns – as risk measures, and 2) the Kelly Formula – to make sure the best ideas get more money applied to them.
The results of my calculations are displayed in the chart on the Optimal Asset Allocation page.