Do you know why you hold the assets you do? Do you know why asset allocation  works?
This graph (from Callan.com) neatly explains  the case for holding a diverse scaffold of components in your portfolio that can cope with different economic conditions and mutually support one another.
The macroeconomic weather can roughly be summed up as:
Stormy – A deflationary recession equals panic stations or a ‘flight to quality’. Stocks are dumped and investors pile into the safest asset class they know – domestic government bonds that have never defaulted, such as UK gilts . Long duration bonds stand tall in this situation as they benefit most from interest rate drops.
Dismal – Commodities are your least worst option during stagflation. Equities and bonds can both wilt when growth is consumed by inflation. The worst ever year for UK equities was a terrifying real-terms loss of 71% in the stock market crash of 1973-74. Bonds were scant protection during this time as a 50/50 equity-bond portfolio plunged 58%  that year.
Heatwave – When the economy overheats then real assets are the best protection for your purchasing power. No matter what happens we still need to eat, keep the lights on and have a roof over our head.
Index-linked gilts1  are the UK version of the inflation-resistant TIPS mentioned in the graph. Linkers weren’t around in the stagflationary 1970s but, as a passive investor , I’d be more inclined to trust them over commodities.
Commodity trackers  are flawed because they’re not particularly good mimics of the commodities market – they’re more Mike Yarwood than Rory Bremner.
The same goes for infrastructure Exchange Traded Funds (ETFs), which tend to correlate more closely with the equity markets than the bootstrapping projects our graph has in mind.
Though equities are renowned for their inflation-proofing qualities, that only pans out over the long-term. A bout of unexpected inflation can severely punish equities.
When we invest in real assets, we’re talking hands-on ownership of property, farmland, or your very own stand of trees. Again, ETFs that track wood-related companies or agri-business tend to behave more in common with the stock market than the underlying real asset class. (In contrast, the UK obsession with buy-to-let may shore up many such investors on this score.)
Not all risks are equal
Because nobody can predict the future, an all-weather portfolio is a tried-and-tested way to ensure you capture at least some of the wind in your sails, without risking being sunk without trace.
Harry Browne’s Permanent Portfolio  is one of the simplest expressions of this strategy.
However, it’s worth noting that whereas Harry allocates 25% a piece to each of gold , cash, equities and long bonds, the economic climate hasn’t proved so even.
Figures for the US, for example, show that growth occurred 80% of the time  between 1928 and 2012, whereas deadly stagflation hit just 7% of the time.
Meanwhile, William Bernstein points out that only Japan has been seriously saddled with deflation  in the last 100 years, perhaps because to ward it off central banks can print money until the cows come home covered in bling if they choose to.
So while bonds protect you  from recessionary trauma that tends to pass quickly, the last 30 years has masked how inflation can munch into them like moths.
Conventional UK bonds lost 73% in real-terms  between 1947 and 1973, and it took until 1993 to breakeven. That’s 46 years – an investing lifetime!
Umbrellas and suncream
So where does that leave us in designing our all-weather passive portfolio?
Equities are still the main source of returns and should dominate given that growth rules recession. The more diversified your equities, the less you’ll be crucified during a downturn – as advocates of factor investing  have argued  for a while now.
A slug of your bond allocation should go to linkers (50% of your fixed income is a good rule of thumb) to ward off the dreaded stagflation. The balance can sit in a mix of cash and conventional government bonds. Hedged international bonds is another way to diversify against galloping inflation in the home country.
I’d find a 5-10% allocation for commodities too, if only I trusted any of the funds.
As I’m not likely to pass my lumberjack exams, maybe it’s time for me to more seriously consider becoming a landlord in order to increase my exposure to real assets?
Take it steady,
- Also known as linkers. [↩ ]