Trying to settle on an asset allocation is a classic cause of analysis paralysis. Financial industry talk of efficient frontiers, mean variance analysis and allocations customised for your unique circumstances can lead you to believe there’s a perfect recipe out there – some financial equivalent of the Ancient Greek’s golden mean.
Sadly, you can only know your ideal asset allocation in retrospect. That’s because nobody can predict with any degree of certainty which combination of asset classes will deliver the best returns after one, ten, or 20 years.
The proper goal of asset allocation is to pick a diversified combo of investments to see you proud in most circumstances. The mix should suit your:
- Attitude to risk – can you handle it when the market tanks?
- Time horizon – might you be forced to sell up at the worst possible moment?
In a minute I’ll run you through a simple method to create a robust asset allocation. We’ll consider what questions you’ll need to ask yourself along the way and some of the rules of thumb you can use to narrow down your answers.
But before that we need to do some spadework.
Asset allocation preparation
You need to know what you’re investing for. Specifically, some hard numbers:
- How much do you need?
- In how many years will you need it?
- How much will you save towards your goal?
- What return can you expect from your investments?
Spend some time thinking about those numbers. The result will be a plan that can be adapted to any investment goal.
Don’t worry if your numbers are a little hazy. Investing is like piloting a ship through the fog. We will make a few course corrections along the way. For now we just need to know roughly where the land lies.
You don’t have to consult your local mystic to work out your return number, either. We’ll get that from the historical record and a smorgasbord of sources that have analysed current valuations. This number will be wrong, but it’s the best we can do and is no more likely to be wrong than anyone else’s best guess. (I’ll write more about this in my next post).
Your return number will be heavily influenced by the combination of equities1 and bonds2 that suits your risk tolerance. Together, equities and bonds are the rocket fuel and crash bags of a diversified portfolio.
- Equities generally deliver decent growth, but occasionally they destroy value like a shredder that suddenly grabs your fingers.
- Bonds generally offer stability and low growth, and help to cushion your portfolio when your equities fall.
Traditionally, 100% equities is the preserve of beings with an emotional temperature near Absolute Zero. Meanwhile 100% bonds is reserved for timorous burrowing creatures who cannot bear loss of any kind.
Most people lie somewhere in between.
Your place on the spectrum is impossible to know with any confidence until you’ve received your first shoeing in the market. The industry uses risk profiling tests in the absence of other evidence, or you could try the risk tool here on Monevator. We’ll also offer an even cruder approach below.
Ultimately, the amount you invest multiplied by the compound return you receive will equal your big number in X years.
If X years is likely to be less than ten, then you’d be very unwise to commit all to equities. More on this below.
Beware too that if your required return suggests an equity allocation above your risk tolerance – or higher than the expected rate of growth – then you’re heading for the rocks.
Rather than ignoring the red warning light and slamming the risk lever to Max Equities while hoping not to crash, you’d do better to save more, reduce your big number, or plan to take longer to reach your destination.
Choosing your equities
Most people must invest in equities because their goals require a rate of growth they’re unlikely to get from bonds, cash, or any of the gentler asset classes.
Equities are inherently risky, so passive investors diversify as much of that risk away as they can by investing in the broadest pools of shares possible.
By doing so, we avoid taking bets on individual companies, industries, countries or regions that could sail down the Swanee.
Instead, we invest in the most diversified equity line up available – the World Stock Market, which currently looks something like this:
|North America (US & Canada)||52|
|Pacific inc Japan||13|
This diversified global portfolio represents the aggregate buy and sell decisions of every investor operating in the world’s major stock markets.
In other words, it’s the best approximation we have of where Planet Earth’s finest investment minds are allocating their capital. As we probably don’t know any better than them, we should do the same.
If you’re a 100% equities buccaneer then you could do worse than replicating that allocation, which is easily done by putting your money into an All-World ETF like Vanguard’s VWRL.
However, few investors want nor need nor can handle an all-in equity allocation.
Bring on the bonds
The point of bonds is to dilute the riskiness of equities. So we want the least volatile bonds around:
- Government bonds – ideally short-maturities, conventional, or index-linked.
- From your home country – gilts for UK investors.
- That’s assuming they’re investment grade – UK gilts are.
- You can use individual bonds or bond funds.
What percentage of your portfolio should be devoted to bonds? Again, there’s no correct answer to that question. It depends entirely on your personality, goals and financial situation.
But we can throw a rope around your number using some general principles and rules of thumb.
Remember, we’re only investing in equities because we need the growth they offer over the long term. If you owned an orchard of money trees and waded through bank notes like autumnal leaves then you wouldn’t have to bother with all that nasty stock market crash business.
So if you don’t need much growth (say just 0.5% to 1% real return per year over the next ten years) then you can hugely reduce your reliance on equities.
In other words, if you’re more interested in capital preservation, then a strong allocation to shorter-dated conventional gilts and index-linked gilts makes sense.
Associated rule of thumb: 100 minus your age = your allocation to equities.
If you need the money soon then equities are a big risk. And by “soon” I mean anytime in the next ten years.
Equities have a 1-in-4 chance of returning a loss inside any five-year period and a 1-in-6 chance of handing you a loss within any given ten years, according to the analysis of Tim Hale in his superb book Smarter Investing.
So do not allocate 100% to equities if you will need all of your money within that period.
Associated rule of thumb: Own 4% in equities for each year you’ll be investing. The rest of the portfolio is in bonds.
If you don’t need the money at all then you can happily increase the risk you take.
For example, if your living expenses are amply covered by income streams such as a defined contribution pension and the State Pension then you could easily up the equity allocation as a proportion of your assets.
If equities plunge in value then no matter, you can ride out the dip and enjoy the upside whenever a recovery comes.
However, your risk tolerance is the house that rules all.
You can have all the money in the world, but if you can’t bear to see a chunk of it consumed by a crisis of capitalism then you should avoid a large dose of equities that could cause you to panic at the worst possible moment.
The nightmare scenario with any asset allocation is that it’s too risky for you. If you sell when markets plunge you’ll lock in losses and permanently curtail your future returns.
Therefore an untested investor is advised to think conservatively – opt for a 50:50 equity-bond split until you know yourself better.3
Sadly, your risk tolerance is a moving target. It’s known to weaken with age and the amount at stake. Therefore even a tried-and-tested investor should reassess their allocation from time to time and consider lifestyling to a lower equity allocation as they age.
Associated rule of thumb: Think about how much loss you could take. 50%? 25%? 10%? Write down the current value of your investments. Cross that figure out and replace with the amount it would be worth after enduring your loss.
Could you live with that if it took 10 years to recover your original position? Limit your equity allocation to twice the percentage amount you can stand to lose.
William Bernstein, in his wonderful book The Investor’s Manifesto, provides handy instruction on how your risk tolerance might modify a rule of thumb like “your age in bonds”:
|Risk tolerance||Adjustment to equities allocation||Reaction to last market crash|
|Very high||+20%||Bought and hoped for further declines|
The rules of thumb aren’t magic amulets. They ward off no future disaster. They are only road traffic signs that will hopefully guide you to the right destination at a relatively safe speed.
Here’s one final rule of thumb: the 60:40 moderate equities and bonds split. It’s become the default industry standard for the ‘don’t knows’ or ‘Joe Average’.
Inflation, deflation, and cash
Remember that conventional and index-linked bonds perform different roles.
Generally, index-linked bonds protect you against inflation and conventional government bonds perform well during recessions and times of deflation. Many people split their fixed income allocation 50:50 between the two.
You can also devote a proportion of your bond allocation to cash.
Cash is vital for short-term requirements– such as paying the bills – but as an asset class it has historically under-performed bonds over the long term. (Nimble private investors prepared to continually chase the highest rates may do far better than average with cash, however.)
Press play to continue
Once you’ve thought through your equity/bond split, you’ve made the asset allocation decision that will have the biggest impact upon your ultimate returns from investing.
The hard work is potentially over. If you like, you can now draw a line under the process – or outsource the fine details to a one-stop, fund-of-funds like Vanguard’s LifeStrategy series
Fine-tuning with property, risk, and global bonds
The following advanced moves should all be taken from the equities side of your allocation.
Global property is the halfway house between bonds and equities in terms of growth and volatility. The performance of commercial property isn’t highly correlated to either of the main two asset classes so it adds a smidgeon of extra diversification.
Allocations to property generally lie between 5 and 20% of the portfolio – typically 10%.
Risk factors are the few slivers of global equities that have a long track record of delivering market-beating growth. They also have a long history of delivering increased volatility, and there’s no guarantee they’ll continue to perform well in the future.
Well known risk factors are value equities and small caps. If the future looks like the past then you might expect a factor like small-value to deliver an extra 1% real return per year (after fees) over its equivalent broad-based index, such as the FTSE All-Share.
But you’d also be throwing in an extra 20% more volatility. Be sure you can handle the risk, or compensate by increasing your bond allocation.
To add risk factors to your asset allocation, divide your regions into broad market, value, and small cap allocations.
For example, 20% UK equity allocation becomes:
- 10% UK equity
- 5% UK value
- 5% UK small cap
Better still, the value and small cap slices can merge into 10% UK small-value.
Global corporate bonds of varying yields and maturities add an extra source of diversification, but should be taken from the equities side due to volatility concerns. Consider a 10% – 15% allocation.
In Smarter Investing Tim Hale allows for an allocation to the most stable corporate bonds – short-dated, domestic currency, investment grade – to be taken from your fixed income allocation rather than equity, as they are not unduly volatile.
Finally older investors may wish to tilt their equity allocation towards their home territory to reduce currency risk. The downside is you’ll be taking a bigger punt on your domestic market.
It’s absolutely fine to carve out your allocations in big 5 – 10% blocks. The odd fiddly percentage point here and there will make little difference to your final score.
I’d avoid adding so many sub-asset classes that you end up with a raft of sub-5% allocations. It just adds unnecessary complexity for negligible gain.
Most investors use model portfolios to help firm up their ideas. Some we’ve written up include:
- Different asset allocations for different types of investors.
- Our own Slow & Steady model portfolio.
You’ll find there’s a good range of low cost index trackers to cover almost any of the asset classes you might choose.
Take it steady,
- Equities are shares in companies, hence their alternative name of shares. Americans call them stocks. [↩]
- Bonds are debts. By buying them, you effectively lend a government or company money. It pays you interest and (usually) returns a capital sum after a fixed period of time. [↩]
- The Investor has even suggested 50:50 equity-cash for new investors. [↩]