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The Asset Allocation Predicament: Part 2

Posted: May 19th, 2014 | Author: | Filed under: Uncategorized | No Comments »

So now that we have established what a tried and true portfolio looks like, we are left with the problem of what to do about the bond allocation of such a portfolio. While there are many similar variations of different reasonable portfolios out there, they all include bond allocations. What is the observant Muslim investor to do?

We can start by quickly reviewing why bond allocations are generally recommended to have in a portfolio. As discussed previously, you want an allocation of a stable asset  in your portfolio so that volatility is reduced. This will provide stability to your portfolio during bear markets when your stock allocation takes hit, preventing behavioral errors (selling off stocks) when large losses are hard to stomach. It also provides stability to your portfolio during your retirement/withdrawal years.

Now most people have recommended bonds as the asset to reduce volatility. However, as long as we have an asset that has some of the above mentioned characteristics, there’s actually no absolute reason we have to be limited to bonds. We want an asset that 1) reduces volatility 2) has low correlation to stocks. Additional hedges are a bonus.

 

correlations aaii_com

Correlations of various assets. Courtesy of aaii.com

 

Let’s examine a few options. Perhaps real estate truly provides the best alternative, particularly with it’s steady stream of rental income.. However, except for those with very large amounts of capital, to enter the real estate investment world without financing is essentially impossible. There do exist financial products to allow the individual investor to take part in larger real estate ventures (REITs), and these have been argued to be an inflation-hedge, however, these use financing for their purchases, which again puts them in Haram Risk murky waters. Furthermore, REIT’s are strongly correlated to stocks. In terms of diversification, you want to own asset classes that not only are uncorrelated or weakly correlated.

How about ‘sukuk,’ which are being presented as ‘shariah compliant bonds.’ These essentially will function just as bonds and as such obviously provide an adequate, if not near identical, substitute. However, the jury is still out on this and most would likely consider this an aggressive play in terms of Haram Risk.

Another option is precious metals, particularly gold. It is the ultimate hedge against currency inflation. Gold has a low correlation to stocks, in fact even less so than bonds. In fact, it has little to no correlation to any asset and this low correlation with other assets gives it a great diversification benefit.It is also a ‘crisis hedge,’ as any time there is fear, whether of inflation, paper assets losing their value, government default, or real estate collapse, people tend to turn to gold because it retains its value.  Again, gold can be regarded  as a store of value (without growth), as oppose to say stocks which are regarded as a return on value (growth from anticipated real price increase plus dividends). At the very least, gold can help one avoid the problem of keeping one’s wealth in cash, which essentially results in one’s wealth being taxed via inflation. Granted, gold will at times have sharp movements in price and can take a long time to mean revert (return to its true value), usually do to speculation and perceived ‘crisis moments’ as mentioned above. However, as long as one is willing to see it through and hold on to it as a long term play while staying disciplined and benefiting from rebalancing bonuses all the while, should ultimately only be noise.

 

growth of 10 k gold

While lagging stocks, beats short-term treasuries. Courtesy of mypersonalfinancejourney.com

 

It is for these reasons that gold wins out as our best alternative for constructing a sound portfolio for the observant Muslim investor. Stay tuned for further details on how to construct such a portfolio.

 

Related Posts:

The Asset Allocation Predicament: Part 1



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