How To Think About Asset Allocation

Pie chart showing asset allocationDon’t put all your eggs in one basket they say. But here we’re talking about nest eggs — the savings you’ve spent years accumulating, and which you plan to rely on for the rest of your life.

As the maxim implies, diversity is the key to protecting your investments. It would be great to know whether shares, bonds, or property will perform the best (and which will crash) over the next year or two — but that is impossible. However, you can apportion your portfolio in a smart way that will offer long-term upside yet should protect you from catastrophic downside.

Our goal is not to find the very best allocation, because no one knows what that will be. Instead, we will help you choose an allocation that has performed well in various scenarios and should not give you a heart attack.

Four asset allocation rules

When it comes to asset allocation, the biggest decisions come down to how much you should have in cash, how much in bonds, and how much in shares. These four rules for asset allocation will help you slice up your portfolio into these important pieces.

Rule 1: If you need the money in the next year, it should be in cash

You don’t want the down payment for your holiday home to evaporate in a stock market — or bond market — crash. Keep it in a savings account. 

Rule 2: If you need the money in the next one to five years, choose safer, income-producing investments

Whether it’s money to put your children through university, or the retirement income you’ll need in the not-so-distant future, stay away from shares.

As with all investments, risk and reward go hand-in-hand when it comes to “safe” assets. Here, we are talking about fixed-rate savings accounts, government bonds with less than five years to run and even corporate bonds. For the latter two, most people will find it more efficient to invest through a fund, rather than buying individual government or corporate bonds. As with any investment, pay close attention to the charges.

Rule 3: Any money you don’t need for more than five to seven years is a candidate for the stock market

We Fools are fans of the stock market, and we know our history. According to the 2016 Barclays Capital Equity-Gilt Study, over the last 116 years, UK shares have returned an average of 5.0% a year on top of inflation. Meanwhile, government bonds managed 1.3% a year, and cash just 0.8%. 

However, investors in shares have to keep the long-term nature of these figures in mind. In the short run, no one knows what shares will do, and they have traditionally been much more volatile than both bonds and cash. But make no mistake: even if you’re in or near retirement, we think a portion of your money should be invested for the long term. 

Rule 4: Always own shares

Over the long term, we reckon that shares are the best vehicles to ensure your portfolio withstands inflation and your retirement spending.

According to another recent Barclays Capital Equity-Gilt Study, shares beat bonds in 80% of all 10-year rolling periods over the last 100 years. The performance of shares against cash is even more impressive, with shares producing a greater return in over 90% of 10-year rolling periods. 

The bottom line is that when you need your money will partially dictate where you put it. 

What else determines your asset allocation? That favorite term among financial gurus: your tolerance for risk.

Risk drives return

Most people base their investment strategies on the returns they want, but they have it backward. Instead, focus on managing risk and accept the returns that go along with your tolerance for it. It’d be great if we could get plump returns with no risk at all. But to achieve returns beyond a minimal level, we have to invest in things that involve some possibility that we’ll lose money.

The good news is, once you’ve identified just how you feel about risk, you’re well on your way to choosing a portfolio to maximise your returns according to that comfort level.

Of course, this isn’t just hypothetical theory for modern investors. The 2000s have brought us two wrenching bear markets (maybe there was something to all that Y2K hullabaloo after all!). Have you been able to hold on — or did you panic and sell? That’s the true test of an investor’s risk tolerance: the ability to cling to those shares as they become worth less and less, while clinging to the hope (based on history) that they will one day be worth more and more.

So ask yourself: What would you do if your portfolio dropped 10%, 20%, or 40% from its current level? Would it change your lifestyle? If you’re retired, can you rely on other resources such as the State Pension or a company pension scheme, or would you have to go back to work (and how would you feel about that)? How you answer those questions will lead you to your risk tolerance. The lower your stomach for portfolio ups and downs, the more your portfolio should be in bonds and cash.

As an extra aid in determining your mix of shares and bonds, consider the following table, from William Bernstein’s The Intelligent Asset Allocator:

I can tolerate losing n%
of my portfolio in the course
of earning higher returns
Suggested % of portfolio
invested in shares
35% 80%
30% 70%
25% 60%
20% 50%
15% 40%
10% 30%
5% 20%
0% 10%

So, according to Bernstein, if you can’t stand seeing your portfolio drop 20% in value, then he reckons no more than 50% of your money in shares.

The power of diversification

Let’s say you were offered a choice from among five portfolios in which to invest for the next few decades. While you know that past results are no guarantee of future returns, you’d probably still want to know how each of those five portfolios have performed over in the past.

So you’re shown this chart:

1972 – 2007

Portfolio A

Portfolio B

Portfolio C

Portfolio D

Portfolio E

Return*

11.2%

11.8%

13.0%

11.7%

13.2%

£1 turned into …

£45.50

£54.53

£81.79

£52.81

£87.31

Standard deviation

17.0

21.7

17.4

24.5

11.0

Sharpe ratio

0.39

0.35

0.48

0.34

0.68

Worst 1-year return

-26.5%

-23.2%

-21.4%

-35.8%

-12.8%

Worst 3-year return*

-14.6%

-17.0%

-10.5%

-9.6%

-0.6%

Worst 5-year return*

-2.3%

-2.6%

3.3%

-4.5%

3.3%

Worst 10-year return*

5.9%

4.3%

9.1%

2.1%

8.7%

* = Compound annual total return.

Source: Roger C. Gibson, Gibson Capital Management. 

Let’s start with the number we understandably care the most about: compound annual return. We see that Portfolio E is the winner, with C not far behind. Down on the next line, we see how earning a percentage point or two more a year can make a humongous difference when compounded over decades. The winner here (E) turned £1 into £87.31, almost double the £45.50 created by the lowest-returning portfolio (A), even though their returns — 13.2% vs. 11.2% — don’t seem all that far apart.

Now let’s take a look at the other side of the coin: volatility, as measured by standard deviation. The higher the number, the more likely the portfolio was to vary widely above or below its “average” return. Here, the winner is E: Its standard deviation of 11.0 is well below that of the other portfolios.

And look at its Sharpe Ratio! That’s a metric developed by Nobel Prize-winning economist William Sharpe, who developed the ratio as a way to measure risk-adjusted returns. The higher the number, the more bang you’re getting for the amount of risk your buck is taking. But you don’t need that fancy-pants number to figure that out. All you have to look at is the worst one-, three-, five-, and 10-year returns. Portfolio E had a darn good compound annual return over those three-plus decades, yet its bad years weren’t quite so bad, relative to the other portfolios.

So which portfolio would you choose? Go ahead, make your choice. Got one? Great!

We should mention that this is a US-based study, but the principles are identical for investors here in the UK. Now, let’s pull back the curtain to reveal what each portfolio held:

  • Portfolio A: US shares (as measured by the S&P 500).
  • Portfolio B: Non-US shares (as measured by the Europe, Australia, and Far East Index).
  • Portfolio C: Property (as measured by the National Association of Real Estate Investment Trusts Equity Index).
  • Portfolio D: Commodities (as measured by the S&P Goldman Sachs Commodities Index).
  • Portfolio E: A portfolio of equal parts of portfolios A, B, C, and D, rebalanced annually.

Now that you know what’s really in each portfolio, glance back at the chart. Surprised?

Portfolio E — the most diversified portfolio — was the best-performing portfolio, and had a much smoother ride. It’s truly a case of the whole being greater than the sum of its parts.

This research came from investment advisor Roger Gibson, author of Asset Allocation: Balancing Financial Risk, which is a great book on constructing a smartly diversified portfolio.

How did they do that?

How can a portfolio have a greater return than the sum of its parts and have lower volatility than each of its parts? The answer isn’t just diversification, but diversification using assets that tend to go in their own directions. Each of those asset classes tend to move to the beats of their own drums, at least to some degree.

In the academic world, this is measured by “correlation” — how much two investments tend to move in or out of sync. And when you combine assets that don’t perform similarly at the same time, the standard deviation of the entire portfolio declines. Throw in regular rebalancing of the weighting held in each asset class, and you not only get less volatility, you also increase your chances for an enhanced return because you’re selling the investments that have done well to buy the investments that have lagged. Since assets take turns sprinting ahead and then taking a breather, rebalancing ideally leads to selling high and buying low.

Despite the impressive numbers put up by Portfolio E, it isn’t necessarily a portfolio you’d own. Gibson himself doesn’t recommend such a mix to his clients.

First of all, most investors should add bonds to the mix. Plus, the exact mix is tailored to each investor’s goals and risk tolerance (just as yours should be). But as an instructional tool that demonstrates the power of asset allocation, Gibson’s illustration is hard to beat.


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