It’s really a question of looking at the possible options where investments can be placed and deciding what proportion to put in each one. The usual classes of investing asset are :
Furthermore, equities can be divided into several sub-categories - large cap., mid cap and smaller companies, emerging markets, UK based or global.
Diversification by asset class and geography is one of the best forms of risk management.
As can be seen from Ben Carlson’s asset quilt, the fortunes of the various assets vary from year to year and it is impossible to determine which will do well in advance. Therefore, holding a diverse mix rather than just one or two classes in your allocation strategy means you capture an average from all parts of the spectrum.
A good asset allocation is not so much about maximising returns, but more about building a robust boat that will ride out the stormy waters and get you from A to B.
Risk Profile & Volatility
When first starting out on the investing journey, I believe one of the least understood aspects is probably the need for every investor to understand their unique emotional make up and ability to withstand the volatility of the markets and then to match this to the most appropriate allocation of assets taking into account time horizon.
Equities are probably the most volatile class but over the long term should provide the better returns. However, I suggest most people are not prepared to see a large percentage of their wealth wiped out over the course of a single month (or even week!) so it is usually a good strategy to hold a diverse mix of assets to reduce this volatility and therefore stand a better chance of riding out the inevitable storms that come along from time to time.
This is where asset allocation comes into play. As we have seen over the past few weeks, some assets such as equities and commodities are far more volatile than other more stable assets such as government bonds (gilts). The FTSE 100 fell by over 10% yesterday, its biggest one-day fall since the crash of October 1987. Individual share holdings are probably the most volatile. For example shares in Shell Oil and BP have both fallen in excess of 40% over just the past month.
With hindsight it was clear I should have sold my investments in early 2000 and repurchased in 2003 but timing these events is almost impossible to achieve. It was probably during this period when I was predominantly invested in equities, that I began to understand the importance of a sensible allocation of assets.
It will therefore be a good idea to have a robust strategy which takes into account our emotional traits and behavioural biases. The journey needs to be planned using a number of sound stepping stones and the first of these will be some attention to asset allocation.
Selecting a plan which contains a sensible mix of equities, bonds and possibly property and then being confident this mix can continue through periods of volatility and market downturns, such as we are experiencing at present, is key to a good outcome longer term.
A classic allocation is 60% equities and 40% bonds but there is no perfect solution - everyone will be unique in their tolerance to volatility. There is probably no such thing as a perfect asset allocation - each person should decide on the best mix, and of course, the mix between different classes of asset can, and probably should, vary over time. As you get older, the time horizon will obviously shorten so many will be looking to reduce equity and increase bonds.
One rule of thumb is to hold the same percentage of bonds as your age - so at age 30 years, it would be 70% equities and 30% bonds. At age 60 years, 40% equities and 60% bonds etc.
Tim Hale, author of “Smarter Investing” suggests 4% in equities for each year you intend to be investing - the remainder in bonds. I would go along with this suggestion but maybe for those of a more cautious disposition who require a more conservative allocation, reduce it to 2.5% or 3% for each year.
Another popular choice is the Harry Browne Permanent Portfolio allocation - 25% equities, 25% gilts, 25% gold and 25% cash. The portfolio is rebalanced once per year to restore any imbalance that has arisen as one asset class does better than another.
Personally, I’m not a big fan of gold, but I can understand why some people will hold a significant percentage in their portfolio as a hedge against currency devaluation. Others regard it as the ultimate safe haven in times of extreme uncertainty such as wars.
One of the benefits of spreading your investments across a number of different asset classes is the reduction of volatility. If you are invested 100% in equities and there is a sudden downturn in the markets, you could easily lose 20% or 30% of the value of your portfolio in a very short period of time - witness late 2008! In May, the FTSE was 6,300 - 6 months later the index had slumped 40% (2,500 points) to 3,800 by November. However, if your investments are mixed between equities, gilts and other fixed interest securities, it is more likely the loss will be more like 10% or 15% which should make it a little easier to ride out the storm.
Whatever allocation you may decide is right for your investment approach, the main point is that you have addressed the issue. Also, I wouldn’t get too bogged down with 2% or 3% in this class and 4% in another - a broad brush is going to do the job and will be easier to manage and rebalance.
Many private investors start off with good intentions, but get sidetracked by the latest trend - with me it was technology shares in the late 1990s and currently fossil-free investments - but it could be smaller companies, emerging markets, commodities and so on, ending up with a dogs dinner of a portfolio.
Work Out Your Mix
First of all, it will to some extent depend on your timeframe - the longer the period, the more sense it will make to have a larger percentage of equities in the mix.
Some people are not very good at assessing the probability of a good outcome - they have unrealistic expectations of what they want to achieve for their level of risk and/or competence. They are sucked in by media stories or discussion boards - time and time again, we read about small investors piling into equities when the markets are near the top and just as quickly become disillusioned when the markets pull back as they always do.
As I say, there are no once-size-fits-all allocation - each will need to settle on their own mix. Of course, when just starting out, its very difficult to know just how you might react to a market correction of 15% or 20%. In his book ‘Investing Demystified’ Lars Kroijer suggests that if investors react badly to market falls, then reduce portfolio equity exposure by 10% - keep doing this until you feel comfortable.
If I were in my 20s or 30s, I could well decide to choose 100% equities, after all, they are the most likely to provide the best return over the longer period. This is asset allocation - its just that I have chosen to allocate 100% to equities. The ride is likely to be volatile but may be OK for those with a strong constitution who are prepared for many ups and downs along the investing journey. Obviously there will be no need to rebalance.
Say I choose a portfolio of 50% global equities and 50% UK gilts - and say at the end of the year equities have done very well and have increased to 60 % of the total portfolio value. This would mean the gilts now represent only 40%. The idea of rebalancing is to restore the original balance of 50:50, therefore I sell 10% of my equities and reinvest the proceeds into gilts. The overall value of the portfolio has increased but the original allocation percentages are always restored at regular intervals.
I am selling those assets which have appreciated in value, and then buying those that have either lagged or depreciated - it seems a little counterintuitive. If we're in a bull market and equities are going up, you have to sell some equities to buy bonds. It could be very emotionally difficult to do - equities may well continue rising for another year or two - so I need to be disciplined and try to remove that emotion from the process.
The only sensible reason to do this is because of the investing principle known as reversion to mean. Whilst many forms of investments, including equities, can trade above or below their long term average - often for surprisingly lengthy periods - in the long term, they always move back in line with that average sooner or later.
To Sum Up
In recent times I have been moving my portfolio away from the balanced globally diverse index funds as I wish to avoid holding fossil fuel companies and the big banks which finance their activities. I have been building my own 'green' portfolio of mainly equities however this was with the full understanding that my portfolio would become more volatile. I have been bringing my investments into line with my values and I have been prepared to accept this trade-off for the knowledge that I am no longer a part-owner of companies that are failing to respond to our climate emergency.
Have a robust investing plan
Be sure the plan takes account of personality
Diversify by asset class and geography
Be patient, stay in the game and keep it simple