When thinking how to invest one´s money, most people think about which stocks to buy, the hot tips of today and the potential stars of tomorrow. Less thought is put into building a robust portfolio, that will stand the test of time: changes in policy, changing economic conditions, emerging new technologies and deprecated business models can all have huge impacts on stock´s performances. There is no way of predicting the future. Instead of relying on luck, there are ways to improve your odds: the magic word is diversification. With this article, we try to give you the basic knowledge for creating a robust diversified portfolio.
We start the article by showing that stocks do not "go up automagically", and investing in a small number of stocks may have destrastous consequences. We introduce the concept of diversification, the only free lunch in investing. By adding other asset classes to your portfolio, we dramatically decrease volatility and create a portfolio that works well in different economic conditions. We carry the concept of diversification forward by diversifying further within the asset classes. Finally we give you some practical advise how to translate the concept of asset classes into financial products any retail investor can buy & sell.
This article covers:
- The Effect of Diversification
- The 60/40 Portfolio
- Beyond Stocks and Bonds
- Allocating Money to Asset Classes
- Diversification within Asset Classes
- Translating asset classes to investment vehicles
So here we are, a (more or less) modest pile of hard-earned money in front of us, and the iron will to invest it. The obvious question of what to buy can lead us down to the rabbit-hole of portfolio allocation. In this article we try a step-by-step approach to give you the tools and the know-how to choose the proper way of splitting your money to different asset classes and among those classes.
First, let´s imagine we invite our best buddy and travel back in time (let´s take a trip way back to 1990). We want to buy some blue chips, and look at the Dow Jones Industrial Averages historic composition (historic because back then the DJ´s composition was different than it is today).
I buy stocks from Goodyear Tire&Rubber Co (GT), because I safely assume future cars will also need 4 new tires every couple of years. My buddy buys Procter & Gamble because despite possible economy booms & busts ahead- everyone has to brush teeth, wash clothes and improve one´s appearance. So we bought those stocks and held them until December 2020. Our initial investment as a graphic through time would look like this:
Now take a sheet of paper, cover the graph and by moving the paper slowly to the right, enjoy my emotional ride through time. First concentrate on the red line:
For the first couple of years I felt like the smartest investor there is on earth. Then something happened, the direction reversed my stock´s price going down for full five years. Then again a slow but steady increase, while never fully recovering. Instead, after 20 years of going sideways, at the end of 2020, I am left roughly where I started (minus the devaluation of my account due to inflation- we come back to that nasty pitfall later).
My friend on the other hand (yellow curve), enjoyed a mostly steady growth of his wealth through time. From time to time, there were also sharp declines, but in total after 30 years he enjoys a whopping 37x increase of his positions value.
With the knowledge of 1990, there was no way of forecasting which stock would thrive- and which one would wither. If I had bought both stocks, the resulting curve of my portfolio value would look like the green dotted line. Less than PG alone, but way better than GT. If back in 1990 we would have had the choice of buying only PG or only GT or both of them 50:50- the latter would have been a rational choice.
Admittedly, this is a very simple example, but lets start easy and increase complexity while we move on. As you can see, by diversifying we reduced the volatility of the overall portfolio, and the risk of chosing the wrong stock and thus loosing money.
What if we look at a basket of stocks? For example let´s have a look at the Standard & Poor´s 500- a very broad stock index covering the biggest companies in the US. Let´s have a look a it´s 30 year performance:
As you can see, despite the fact that the S&P500 contains, well, 500 different companies, you can see up´s and down´s quite similar to our above mini-portfolio of 2 stocks. Why is that? Shouldn´t be 500 individual stocks enough to smoothen the effects of thriving and withering companies?
All stocks belong to an asset class called equities. In fact, by buying a stock you buy a fractional ownership issued by the company. Stocks in general have a pretty high correlation with each other. While it would take another full article to explain correlation und it´s diversifying effect (and we will publish one in the future), for now it should suffice that the stock markets in general move up and down in a quite similar fashion. Especially during "stock market crashes"- pretty sharp corrections of an index- stocks in general loose a lot of their value in unisono. Look at the down spikes in above picture in 2000, 2008 and early 2020.
And, just for a fun exercise, and to prepare you what can happen in stock markets, repeat above cover-the-chart-"simulation". When you come to early 2000, imagine you would have invested the largest share of your money now, as everyone told you "stocks tend to go up in the long run". A long run indeed, for the next 14 years you will be in drawdown, at some times almost your portfolio will be worth only 50% of your initial investment.
So, it makes sense to look for other asset classes, which move independently from equity markets to further smoothe volatilty. If you search for ways to diversify your portfolio, you will find a lot of references to the "60/40" portfolio.
These types of portfolios invest only 60% of their money into equities, and the other 40% into bonds. Bonds are fixed-income investments in debt securites, issued by governments companies (the latter called corporate bonds). We will concentrate on government bonds for this article (as states tend to go bankrupt less often than companies).
Let´s have a look how those two different asset classes relate through time and how the 60/40 combination performed:
We assume a starting balance of $100,000. All returns are real returns, adjusted by inflation. For the full methodology, see the last chapter of this article. As you can see in the orange curve, bonds tend to move differently than stocks. Especially during times of recessions, while equities (blue curve) move downwards, bonds tend to rise. The resulting 60/40 allocation curve in yellow looks much smoother than the equity curve on the hand hand, and for the most part of the time, performed better or equally as bonds or equities alone. This led to the familiar expression "Diversification is a free lunch". If it is done right, of course.
Especially for the coming decade of the 2020ies, there are a lot of predictions that the 60/40 portfolio might not perform as good for the coming years, compared to historic returns. The argument for the underperformance is due to artificially inflated prices for equities that do not leave a lot of room for further growth. At the same time low interest rates limit the returns of bonds. Whether you believe such forecasts or think it is too early to write an obituary for 60/40- is there something beyond equities and bonds?
Equipped with above´s knowledge about the effect of diversifying a portfolio, are there other asset classes we can invest in, thus further increasing diversification? Besides equities and bonds, you might be familiar with real estate and commodities. And you don´t have to buy houses and oil barrels to invest, there is a whole toolset of financial products available. Another less known asset-class are TIPS, Treasury Inflation-Protected Securities. Very similar to bonds, those securities are also issued by governments, and constructed in a way that increases their value if inflation is rising.
Bevor blindly buying any of those it makes sense to invest some time to think about how the different asset classes behave in different economic scenarios. See above table for a rough summary. The assessments are qualitative, not quantitative and should give you a general overview. As all asset classes can be considered as very large bins for a large spectrum, for each generalisation one might find a dozen cornercases that contradict that. Commodities for example contain such different goods like soybeans, gold and crude oil.
As you can see, different asset classes complement each other during different economic scenarios. And you see why it makes sense to have not only stocks in your portfolio, especially when considering a long time horizon. Let´s have a look at the individual returns for those classes:
As you can see, most asset classes move very independently from each other, with one exception: Bonds and TIPS have a very high correlation and move in tandem. So if you like to keep your allocation plan simple, and/or you are investing a smaller amount of money, it makes sense to concentrate on either one.
Above graphics again shows real returns, adjusted by inflation with a (fictional) starting balance of $100,000. Later in this article, we will cover how those asset classes can be translated into actual investment vehicles, something you can buy and sell.
That´s the theory so far. We know we have different asset classes, and that it makes sense so spread your money across them. How to split your pile of money for the different baskets is a question you can debate endlessly... I personally think there is no one-size fits all solution.
You have a full range of options. A very simple approach would be to just cut your money into five equal parts and allocate 20% to each asset class. Or, you can give the five different asset classes weights, based on the historic volatility, so assets with lower volatility have a higher weight in your portfolio. Consider for example this allocation:
As you can see, the more volative classes Equities and Commodities have lower weights than the less volatile Bonds, TIPS and Real Estate.
Another option would be to choose weights based on your risk appetite (which should loosely correlate with your age/ remaining years until pension). For example my personal allocation looks like this:
I personally keep about 10% in cash, just in case interesting buying opportunities show up. Also, I ramped up the equities portion, because I cultivate a more active trading style when it comes to stocks, and smaller portions would limit my freedom of action too much.
Lets have a look how those three different allocations would have performed in recent years:
Interestingly, the results of the three very different allocations do not differ THAT much (sure there are times one outperforms the other, but in general they behave quite similar).
If you are interested in an assessment of 10+ different portfolio allocations I recommend reading Meb Faber´s book "Global Asset Allocation: A Survey of the World's Top Asset Allocation Strategies" (see https://mebfaber.com/books/). Meb takes a scientific approach and looks at historic performance of those portfolios through decades of data.
In the end he comes to a quite simular conclusion: as long as you have all building blocks while constructing your portfolio, the question of how big exactly each basket should be becomes less relevant. Way more relevant is how often you rebalance, and the fees and taxes attached to this. Before we touch the more tactical question what to buy, one more piece of the puzzle to complete the picture.
As I already mentioned in the course of this article, asset classes can be divided into sub-classes. Equities, for example can be divided based on stock market sectors. A quite useful taxonomy is called Global Industry Classification Standard and divides sectors further down to industry groups, industries and sub-industries.
You can take that one step further and also diversify based on regions (like North America, South America, Europe, Asia-Pacific, Afrika) or even by country.
The same logic applies for Commodities- drill down one level and you see different sectors:
Bonds? Also possible, based on country, maturity dates. Real estate? Country, residential/ industrial/ commercial real estate (in fact, see the last category of the GICS taxonomy).
So what? The very same basic rule we stated at the beginning can be applied to sectors (and any further sub-category within asset classes): do not put all your eggs in one basket. As we are already diversified across different asset classes we adapt the rule: do not put all your equities eggs/commodities eggs/... in a single basket. Either buy a couple of different equities eggs (/commodities eggs/ ...)- or buy a broad index that does that for you.
Which leads us to the grande finale of this article. Equipped with all that strategic knowledge, how to translate that into action? What investment vehicles can we buy? Again, a lot of the answer depends on your personal preferences.
If you want your portfolio as easy as possible, buy ETFs that cover as much of an asset class as possible. For equities you could buy an ETF that models the MSCI World- and you are set with that asset class.
For commodities you could do the same: buy an ETF that models a broad basket of commodities like the "Thomson Reuters Equal Weight Commodity Index"- and leave it as is. The same is true for REITs and TIPS: all big players in the ETF space offer allround-ETFs that invest in dozens/hundreds of REITs and TIPS.
For bonds we would suggest, that you also go down the ETF-route: most government bonds are not available for retail traders, or better: the position sizes are so big that by buying one single position you would introduce a huge cluster risk to your portfolio- which is exactly what we are trying to avoid. Instead, buy a fund or ETF that does the diversification in bonds for you. There are also dozens of flavors: by maturity, by region, ...
If you want a more control- you can emphasize sectors, regions or invest guided by ethical/ecological considerations. Go down the ladder as far as you want: buy specifically tailored ETFs, or stocks, or a mix of both. That way you can tailor your portfolio to the specific sectors and/or regions you think will perform best in the future.
As long as you stick to the overall allocation of the five asset classes, you can make it as easy or as complicated as you like.
Just as an example, above portfolio breaks down the allocation you´ve already seen above in some classes, while keeping it simple for others. The overall allocation (30% equities, 30% bonds, 10% each for commodities, TIPPS and Real Estate and 10% "war chest") stays intact.
Remember you have to pay fees for buying and selling, and also taxing can have a bigger impact. The smaller your capital, the less different positions you should own.
Some final thoughs about nurturing and maintaining your portfolio throughout the time. One aspect of above´s allocation performance curves I did not mention yet is the rebalancing. With time, your positions will develop differently: some will go up, some will go down. This causes the allocation of your portfolio to go out of sync. From time to time you will to sell some of the assets that went up, and invest in those that went down, so your overall allocation is re-established. Above curves assumed a fixed allocation and utilized monthly data.
In an ideal world, you wouldn't have to pay fees, and could rebalance on a daily basis (in fact, that is a service that is offered by a lot of so called robo-advisors- computer programs that manage your portfolio). In a real world, you most likely will have to pay fees, which again hit a small depot harder than a large one. You again have to find a sweet spot between the ideal allocation, fees you have to pay, and the time you are willing to invest. Don't overthink it, for most retail investors a quartly, bi-anual or even yearly rebalancing will be enough.
In this article we showed you the only free lunch in investing: Diversification. We introduced a couple of asset classes and discussed how to distribute your capital to those asset classes. We showed that there is no ideal allocation, as long as you have all building blocks for diversification in place.
We finally discussed some practical aspects, how to translate asset classes into financial products a retail trader can actually buy and sell.
Enjoy Life and Happy Trading!