Asset Allocation & Portfolio Diversification
Asset allocation involves dividing an investment portfolio among different assets such as equities, bonds, and cash. The asset allocation that works best for you at any given point in your life will depend largely on your time horizon and your ability to tolerate volatility and risk.
The practice of spreading money among different assets is known as diversification. Nobel Prize laureate Harry Markowitz famously said that “diversification is the only free lunch” in investing. What he meant was that diversification has the ability to reduce the risk of your portfolio without compromising expected return. By picking different assets, you may be able to increase returns or reduce volatility. Diversification can be neatly summed up by the saying “don’t put all your eggs in one basket”.
Passive Index Investing
I am a passive index investor. Passive investing broadly refers to buy and hold assets for the long term with minimal trading in the market. Index investing is the most common form of passive investing where investors hold a broad market index such as The Vanguard FTSE Global All Cap Index fund. Passive index investing is cheaper, less complex, and often produces superior results compared to actively managed portfolios.
With passive investing, you don’t worry about ‘stock market crashes’ or ‘rallies’. There is no need to ‘time the market’, pick winning companies, or convince yourself that you have special powers to beat other investors – especially since the vast army of superbly equipped professionals cannot reliably outperform either. As long term passive index investors we don’t worry about short term volatility.
Asset Allocation Options
History tells us that Equity provides the highest return over time and is, therefore, the best asset to use for wealth accumulation. Equity also has a high level of volatility, so if you are fearful and couldn’t stomach a 30% fall in your Equity portfolio, this is when an allocation in Bonds or other assets will help calm the nerves.
Portfolio diversification trims peaks and valleys for a smoother ride and is the best defense against uncertainty. Generally speaking, the shorter your time horizon, the more important diversification becomes. Alternative asset classes to Equity and Bonds can also be used to spread risk and reduce volatility, which is particularly useful when wealth decumulating (i.e. spending your portfolio at retirement).
The asset universe is extremely broad and these are just a few examples of some that can be used to diversify a portfolio:
Equity and Bonds can be broken down into many subsets with the aim of producing returns greater than the equity market or bond market as a whole. For example; small cap, value, growth, short term bonds, junk bonds, etc. (Global index funds cover all market sectors, geographical sectors, and subsets in one fund).
Cash in the form of savings accounts and cash equivalents such as short-term (1-3 month) Treasury Bonds. You must keep cash easily accessible for emergencies.
Infrastructure is popular when governments looking to reboot economies are investing, for example, in renewable energy. An attraction of infrastructure is that returns are broadly reliable; often inflation linked to 20 or 30 year government contracts.
Real estate is lowly correlated with equities but highly correlated with the economic environment. The collapse of Arcadia and Debenhams serves as a reminder of the risk.
Commodities usually refer to raw materials used in the production of goods – metals, energy, livestock, and agriculture. Investors typically turn to commodities to hedge against uncertainty and inflation as commodities are usually lowly correlated to both stocks and bonds.
Gold is often the panic asset of choice and did well during the coronavirus crisis. It can be used in a portfolio as an insurance policy in times of stress but is extremely volatile.
Don’t forget cryptocurrency which is a whole new ball game on its own!
Modern Portfolio Theory
Modern Portfolio Theory is risk management investing based on combining non-correlated assets to create a portfolio with risk lower than the average risk of its component parts. For example, when equity falls in value, bonds tend to increase in value and vice versa i.e. low correlation. By holding different ratios of Equity to Bonds the volatility of a portfolio can be reduced.
Model portfolios have been constructed to show how different ratios of assets can maximise returns, reduce volatility, or a mixture of both when measured against historical data. Examples include the All-Weather Portfolio, Permanent Portfolio, Golden Butterfly, and Couch Potato.
The Couch Potato portfolio simply consists of 50% S&P 500 and 50% 20+year long term US treasuries.
The Permanent Portfolio consists of 25% of each asset: stocks, long-term bonds, short-term bonds, and gold. The philosophy here is that when the economy is expanding stocks and bonds do well, during a recession short-term bonds and cash do well, during inflation gold does well, and during deflation long term bonds and cash perform the best. When you mix these assets together, the sum of the total portfolio can be greater than the parts: mixing two or more volatile assets in a portfolio can reduce the overall volatility depending on the asset correlation. These model portfolios of mixed assets can help an investor to decide how much risk they are prepared to take to gain higher level of returns.
This is still Passive Investing, using index funds and no active management, just more asset classes. Buy and hold, rebalance annually.
Asset Allocation in 2020
Take the year 2020 as an example of a very volatile year with worldwide stock markets falling by 20-30% in a matter of days due to Covid, but bouncing back very quickly (Keep in mind that you can’t judge investment strategies by a single year).
The Vanguard FTSE Global All Cap Index fund (ie 100% stocks) returned 12.5% but with a standard deviation of 27.5%. Standard deviation is a measure of the volatility of a fund: the bigger the number, the bigger the ups and downs from the average price - between December and March 2022 a portfolio holding just this fund fell in value from £1000 to £833.
The FTSE UK All Share Index finished the year down 10%, while other assets like gold and bonds increased in value as the stock market fell.
The Couch Potato portfolio returned 15% for a relatively low standard deviation of 12%.
The Permanent portfolio returned 13% (this strategy usually returns 5%-7%) and had a low risk standard deviation of just 8%.
If you do set up a portfolio of mixed assets, you will have to choose a balance e.g. 25% Equity: 25% Bonds, 25% property, 25% gold, and then maintain this by Rebalancing. Periodically rebalancing your portfolio by selling down winning assets to buy more underperforming assets can boost your returns. It keeps volatility closer to your tolerance levels and reduces the risk of your portfolio being exposed to bubble markets.
Often the only time people wonder whether they should have rebalanced is after a big stock market downturn. If you have diversified your portfolio into different assets to reduce volatility and improve risk/return characteristics, it makes no sense to abandon this just because one asset class has boomed and another slumped.
Most investors eventually conclude that complexity only offers the illusion of sophistication and they are actually better off keeping things simple. There is a mountain of evidence showing that passive investing is a superior strategy compared to believing that the latest hot fund manager or investment scheme will smash the market. Use low-cost, global index trackers to reap the market returns and get rich slowly.
It’s as simple as investing gets. You can get by with just one low cost global index fund of Equity and Bonds balanced according to your risk profile.