How should we split our portfolios between the various asset classes?
Last week, I wrote that many investors fail to adequately consider the asset allocation of their portfolio. Asset allocation, I explained, had a significant impact on risk, and even on the overall return.
Diluting the amount devoted to equities, and placing a proportion of your wealth into corporate bonds and gilts might shave a little off the eventual return, but should dampen the volatility that an equities-only portfolio experiences. Between June 2007 and March 2009, for instance, the FTSE 100 fell by 48%.
Protecting retirement
As you get older, the question of asset allocation becomes increasingly important. Simply put, you've less time to recover from the sort of declines that we've seen over the past two years -- especially if those assets are in a SIPP (or other pension fund) and are destined to be converted into an income-providing annuity.
And even if your shares aren't in a SIPP, quite apart from falling share prices, many of us are seeing the companies that we invest in declare cuts in the dividends that they pay -- or even abandon dividend payments altogether.
As a result, as you get older, it makes sense to have proportionately less money in shares, and proportionately more money in other assets. But not just any asset. I'm talking about assets like bonds and gilts where the volatility in values can reasonably be expected to be less than that experienced by a portfolio that's 100% invested in equities. Swapping -- say -- shares for property will increase the diversification of your portfolio, but do relatively little to reduce its in-built volatility.
Cash, bonds and gilts
It's true, of course, that on one level many of us know this. But as I argued last week, there's ample evidence that knowing it and doing something about it are two very different things.
Huge numbers of people, it seems, rely on keeping a proportion of their portfolio in cash as their only buffer against equity volatility. By all means have some cash, but have an amount that's been carefully considered.
As I pointed out last week, while shares handsomely outperform cash, research such as the long-running Barclays Capital Equity Gilt Study series shows that equities' long-term margin of outperformance over bonds and gilts is rather less. So investing in bonds and gilts usefully buys a cushion against volatility without costing the earth in terms of performance.
How much?
So let's cut to the chase. How much in equities? And how much in cash, bond and gilts? (For the sake of simplicity, I'm ignoring here asset classes such as property. If you're a fan of property, consider lumping equities and property together -- my focus here is on the proportion of the portfolio to be kept in cash, bonds and gilts.)
One oft-quoted piece of advice is a rule of thumb that's related to your age. Simply put, if you're 20, you should have 20% of your assets in cash, bonds and gilts, if you're 30, it should be 30%, and so on. (See our recent podcast transcript on asset allocation for a fuller discussion of this.)
I think there's a lot to be said for a rule like this. It may have its imperfections, but at least it provides a rational basis for reducing the amount of the portfolio held in equities as one gets older. One might quibble about the exact splits -- and the split between cash, equities and bonds -- but the basic idea is there.
But here's why I especially like it. As Fortune magazine points out just this week, we're all living longer. A man reaching 65 this year has a 50% chance of living to 83, while a woman reaching 65 has a 50% chance of reaching 85. In the case of a 65-year old married couple, there's 50% chance that one of them will see 90.
In other words, being out of equities entirely by the time one retires (as some advocate) is to deprive people of some of their best investing years -- those years when compound growth has the chance to work its miracle on at least a decent-sized proportion of what could be a fairly hefty portfolio.
100% cash, bonds and equities? Never!
More on asset allocation:
