≡ Menu

Asset allocation for all weathers

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 all-weather portfolio

The macroeconomic weather can roughly be summed up as:

Sunny – High growth and low inflation are the ideal conditions for business to thrive in, and thus for equities (shares) to power your returns.

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,

The Accumulator

  1. Also known as linkers. []
{ 27 comments… add one }
  • 1 helfordpirate March 17, 2015, 1:01 pm

    Your comments on commodities are interesting – I share the same nervousness despite having 6% of my portfolio allocated to Broad Basket Commodities (in the equity part).

    (I use the Lyxor funds CRBL (and CRNL) which I believe have tracked their index with an error of about 3% over the last five years. They are swap based and a reasonable TER of 0.35%.)

    They are certainly not showing any correlation with global equities at the moment!

    I try to console myself that the significant drag on returns over the last few years will be compensated for by less pain when equities turn down and that I am also buying myself some extra inflation insurance along with my linkers.

    I did my research on contango and the risk of front running etc and decided to hold the asset class anyway. When it is getting beaten down it is natural to think it was a mistake, but I am staying the course and have been rebalancing into commodities recently (though not with a whole lot of enthusiasm!).

    Would be interested hear other views from those who have researched the asset class.

  • 2 dawn March 17, 2015, 3:55 pm

    Having finally decided not to go 100 % equities, I’m having trouble with what to do with fixed income. I would jump into bonds no problem , I like whats been said here, the linkers and the hedged international bonds but I fear this much talked about bond bubble thats predicted to burst soon. I’ve even considered EM bonds. Maybe too risky though. So I’m sitting in cash at 2% interest which is ok while inflation is so low though. Reading on A Wealth of Common Sense he states “nobody knows what to do about bonds”!

  • 3 Ravic March 17, 2015, 4:56 pm

    Another great article. The key takeaway here is passive investment for an all weather portfolio, not chasing returns by switching to this n that, that is active management and a whole other topic. Take all the assets in the picture and equal weight them using the most “appropriate” vehicle. Whether that is a BTL flat or a REIT ETF, or a forest in Scotland, or a synthetic Wood ETF baked by Swaps and Derivatives, it’s up to you to decide. Remember though, diversification amongst implementation is just as importance as diversification amongst assets, i.e. keep a bit of property, keep a few ETFs backed by real shares and bonds, keep a few synthetic ETFs, keep a bit of cash and you’ll do much better than those that don’t.

  • 4 weenie March 17, 2015, 5:00 pm

    Depending on your risk appetite, peer to peer lending for some (not all) of your cash, Dawn? You’ll be getting between 5%-10% instead of 2%

  • 5 The Rhino March 17, 2015, 5:21 pm

    @weenie is your peer to peer approach based on never taking the capital out, or have you factored in the illiquidity and still think the juice is worth the squeeze?

    i.e. do you consider your peer to peer investments to be liquid like cash, or illiquid, say like a property?

    the problem i have is that if you want to get out of peer to peer you either have to plan 3 to 5 years ahead, or take a hit in terms of losing a few percent in fees. If you’re making say 5% but you get hit with 2-3% on way out then its not clear if its worth the extra risk

  • 6 Ravic March 17, 2015, 6:07 pm

    The key here is to invest in a broad spectrum of assets, using various implementations, this ensures minimum correlations between returns.
    Piling into an asset classes that has done well is too late. I was buying equities in 2008/09 when others were selling. I’m starting to sell equities now and buying commodities. It is called rebalancing and its not rocket science. It just requires conviction and discipline to stay the course, unfortunately most people just can’t do it because they chase returns and listen to popular media.

  • 7 magneto March 17, 2015, 8:10 pm

    Re : Commodities,
    Have for some years overweighted and underweighted Blackrock Blackrock Commodities Income Investment Trust (BRCI) in it’s roller coaster ride, dependent on running yield. Certainly not correlated with stocks in recent years, so a useful diversifier. BRCI does have a healthy yield, useful in retirement, but be aware payouts could be cut in the present environment.
    Must point out that the ongoing charges are high, and not what most investors here would think acceptable.

  • 8 magneto March 17, 2015, 8:14 pm

    Forgot to say thanks for another insightful article.
    Thank You

  • 9 Passsive Investor March 17, 2015, 8:34 pm

    @ Helford Pirate – I researched and had a small amount invested in commodities 5 or 6 years ago. I got very concerned about contango and the lack of roll return that went with this. Without the roll return a commodity ETF just becomes a bet on future commodity prices with a very large head wind. Someone somewhere said that if you don’t understand an investment then you should be invested and i eventually felt this applied to me. For what its worth I am about 50% in equities (10 years from retirement but quite risk adverse) with the rest in shortish duration bond funds / linkers funds / cash and buy to let.

  • 10 Passsive Investor March 17, 2015, 8:39 pm

    Sorry that was ‘should NOT be invested’ . This is from the ETF website on the problem with contango:

    The roll yield, in turn, depends on whether the futures market is in contango or backwardation. The magnitude of the impact of these market traits on ETC returns should not be underestimated. For instance, in 2009, although the spot price of crude oil increased over 50%, contango negated almost all the gains.

    Worrying to say the least

  • 11 weenie March 17, 2015, 9:36 pm


    My own peer to peer approach is to consider it illiquid – it’s not cash that I’m looking to call upon in the near future. At some point, I may stop reinvesting the repayments and the interest I’m getting monthly but for now, I’m just happy letting it all compound.

    Much like the money I’ve put in funds, trackers or shares – I’m not intending to cash those in any time soon.

  • 12 tex_mex March 17, 2015, 9:55 pm

    Thanks for the informative read.

    Is it just me or does the chart look a bit flipped? Seems that the upper left and the lower right quadrants should be flipped. Not trying to be picky, it was just a little bit confusing given the indexes and what I took to be increasing (up/right) and decreasing (down/left).

  • 13 The Investor March 17, 2015, 10:26 pm

    @ravic — A bit off-topic, but I’d beware ETFs as a way to get exposure to forestry/timberland, especially if you mean the Blackrock vehicle which last time I looked was effectively an S&P tracker (it holds lots of sawmills and so forth that are geared into the economic cycle).

    Timberland/forestry is a very hard asset class to buy easily and cheaply. There were a couple of specialist investment trusts launched a few years ago, and they’ve both been awful investments.

    I used to hold Plum Creek (a US Reit) but it has some of the problems I mentioned with the ETF. It does also hold a lot of forestry though.

    The trouble with being linked to production/consumption (sawmills, processing etc) is one of the benefits of forestry traditionally is that you can cut when it’s profitable to do so and leave it grow (and get more valuable) when not. That doesn’t work when you’ve mills to turn and people to pay etc.

    There were a few specialist (unlisted) funds that used to periodically open and close a few years ago that got a fair bit of press. I wonder what happened to them, if anyone knows?

    Does seem a bit of a gap in the market. The UK has plenty of managed forestry, and plenty of investors who like it (albeit partly for tax breaks that I doubt would apply to a fund).

  • 14 DW March 17, 2015, 10:54 pm

    Thanks for an extremely helpful article. I’ve taken the graphic to mean that you need something from each quarter to prove most effective against differing economic conditions, so it’s shown me where I should be focusing my investments and WHY. I understand that no asset classes are equivalent but it’s useful to know that I would have some kind of ‘insurance’.
    I’ve not really considered property as an asset class much previously but this article made me look into REITs. The amusingly named Reita website at http://www.bpf.org.uk/en/reita/index.php has been most useful in learning what is available in the UK.
    How does commercial property compare to residential as a part of a portfolio? I consider UK houses to be well overpriced at the moment so couldn’t convince myself to put much that way, but would consider commercial property if the market is different.
    It’s also bolstered my urge to put a chunk into inflation-linked gilts at the moment as they are probably cheap due to inflation being so low. Of course I may be way off target!

  • 15 Mathmo March 17, 2015, 11:55 pm

    Nice article.

    If you do become a landlord, how will you rebalance your portfolio? Will you include the mortgage on the btl as an offset on the asset? Leverage on the entire portfolio? A negative allocation to bonds?

    I’ve been struggling with this myself – wonder what the pure passive answer is. In the end, I took the asset net of mortgage and put outside of my rebalance. It’s too big and too illiquid to practically manage, even though I know rebalancing’s critical to a well-allocated portfolio.

    I went for gold as my commodity allocation

  • 16 helfordpirate March 18, 2015, 12:00 am

    @passive investor
    Re contango. My conclusion was that in a broad diversified commodities holding (not just oil or gold say) I would have a mix of contango and backwardation and that this was just part of the random walk of commodity pricing – oil has recently been in backwardation for example.

    That said other CCF indexes claim to have better roll strategies than CRY to avoid losses..

    Your comment on don’t invest in what you don’t understand is fair. I think I have done a bunch of work on it – but I’m still not 100% clear…

  • 17 Passive Investor March 18, 2015, 6:49 am

    @helford pirate – you may well be right about the mix of contango and backwardation over the medium term. I got concerned about a lot of commentary at the time saying that passive commodity funds (and the vast amounts of new money in the commodity markets) had changed the market in favour of contango. Also that passive instruments (unable to control length or timing of futures contracts) were a sitting duck (compared with direct investors with flexibility and who were on the other side of the contract). In the end it was the feeling that I didn’t fully understand the source of the return (in abroad diversified commodity fund), the thought that investment should be simple and the worry that I was buying into the latest gimmick that made be stick with bonds / equities / buy to let. Who knows whether that was the right decision for the long term (it was a lucky call five years ago for sure). ?

  • 18 Tim G March 18, 2015, 2:55 pm

    Another great article. I’m interested in how this transfers to the real world. What are the likelihoods of each of these scenarios occurring?

    If they are equally likely, then maybe we should invest equally in each. If not, then I guess we have to weight them.

    You suggest that the most common scenario is the bottom right quadrant of growth without excessive inflation, so that fits with the general preference for equities over other assets.

    The suggestion that 50% of the fixed income allocation should go to bonds seems to imply that stagflation is as likely as low growth + low inflation. Is there any evidence for or against this view? (Not sure if I’m being over-literal here!)

    I can imagine that the top right quadrant (high growth + high inflation) is actually fairly common, but it seems that the assets in this quadrant are not easy to invest in. I don’t consider my own home to be a part of my portfolio, as I need to live in it. I also think that there is a lot of self-deception around buy-to-let, including a tendency to ignore the project management work it often involves, overestimate income and underestimate expenses (returns calculated on the basis of best-case scenarios) and, perhaps worst of all, ignore the fact that it involves concentrating a lot of risk in a single asset.

    Judging from the comments, a lot of people respond to this problem by investing in something that looks like this asset class but really isn’t (‘commodities’ ETFs, for example). I wonder if it would be better just to accept that most of us can’t access this asset class, and leave it at that.

  • 19 oldie March 18, 2015, 3:48 pm

    Again an interesting article.

    Easy to understand but I think difficult to implement. What is high growth? Whose deflation? In the world, US ( as the largest investible market), home market? Some evidence that high growth does not lead to high returns.
    You could assume high growth occurs more often (does it?) and weight the high and low growth chunks accordingly.
    Would you see inflation and growth rates changing anyway and adjust asset holdings.
    W Buffett suggests that good asset back equities will see you through most situations in the long term.

    Thanks. Something to think about.

  • 20 magneto March 18, 2015, 5:54 pm

    @Tim G
    “I also think that there is a lot of self-deception around buy-to-let, including a tendency to ignore the project management work it often involves, overestimate income and underestimate expenses (returns calculated on the basis of best-case scenarios) and, perhaps worst of all, ignore the fact that it involves concentrating a lot of risk in a single asset.”

    Yes self-deception is a trap many investors probably fall into with BTL, as we have witnessed in earlier discussions here with some fanciful over-optimistic calculations, esp involving gearing.
    We may see as the media suggests, another rush of monies into BTL with the impending changes to ‘free up’ pensions, and perhaps some sad stories.
    But don’t write off BTL completely. As investors we should always keep an open mind.
    A number of smaller properties (to spread risk) without gearing, offers a just about acceptable yield of 4%+ real in the currrent market less whatever ‘hassle factor’ the investor determines. Difficult to match that at present with other asset classes, and much much more importantly a terrific diversifier, as stock and real estate valuations seldom seem to move in lock-step.
    Watching rental yields is the key to this asset class, and current real yields are as noted are a little better than most of the competing asset classes, but in a curious hot market of too many investors/monies chasing too few assets (stocks, bonds,RE). RE yields are nowhere near the comfortable levels on offer mid to late 90s, then 10%+ which gave a substantial safety margin for error.
    Biggest snags? Illiquidity and bad tenants.
    Are we buying more RE at present valuations? : NO.

  • 21 dearieme March 19, 2015, 1:04 am

    Postage stamp corner: how about buying shares in Statoil? (How do you do that by the way? Is it on the London SE or do you have to buy in Norway?)

  • 22 magneto March 19, 2015, 12:45 pm

    dearieme March 19, 2015 at 1:04 am

    Postage stamp corner: how about buying shares in Statoil? (How do you do that by the way? Is it on the London SE or do you have to buy in Norway?)

    One simple option buy Staoil ADR (American Depository Receipt?) on the US market. Get form from broker to avoid double taxation.
    TD Direct can help. Not sure if can be put in an ISA.

  • 23 The Accumulator March 20, 2015, 8:19 pm

    @ Dawn – anyone who’s not 100% equities should go bonds / cash. Worried about poor returns? That’s not the point of fixed income. They’re job is to provide you with stability which they will do. Stick with short-term bonds if you’re worried about losses.

    @ DW – property in this sense is commercial not residential. Many UK investors already have a fair chunk of their wealth tied up in residential i.e. the mortgage!

    @ Tim G – you mean 50% of the fixed income allocation to index-linked bonds. The piece quotes evidence for the likelihood of stagflation but bear in mind there are two high inflation scenarios and inflation is more likely than deflation. Also, high inflation can devastate your wealth in short-order. Remember too that linkers are the only convenient, easily accessible and understood inflation-resistant option available – given the problems identified with the other assets that are meant to work in this scenario.

    @ Oldie – are you thinking of no evidence linking GDP to high growth? Bear in mind the old adage, in the short-term the stock market is a voting machine, in the long-term it’s a weighing machine.

    The best answer to deflation exposure is long-term bonds. Doesn’t matter where it comes from if you’re exposed to it, and the solution is the same. But you may consider it a relatively unlikely scenario. William Bernstein argue’s that inflation is the bigger risk in his book Deep Risk. The all-weather portfolio aims to defend against all scenarios though. We only need to think about the last 7 years to consider the futility of forecasting the future though. The bond apocalypse hasn’t happened, hyper-inflation hasn’t happened, now the spectre of deflation looms large – will it take hold? Nobody knows but deflation proof assets are only cheap when it’s not expected.

  • 24 Tim G March 21, 2015, 1:02 pm

    @DW “I’ve taken the graphic to mean that you need something from each quarter to prove most effective against differing economic conditions, so it’s shown me where I should be focusing my investments and WHY.”

    This is what slightly concerns me about displaying these conditions as a quadrant. It can make an active decision (which risks and opportunities do I need to incorporate into my portfolio, and to what extent) feel like a passive one (4 broad scenarios = 4 broad asset classes).

    If we’re not careful, it can be taken to imply that: i) each of the conditions is equally likely; ii) each has the same scale of impact; iii) but (fortunately) there are investible assets to cover each.

    In reality, it’s just as likely that one of the situations is much more likely or unlikely, that there will be disproportionate impacts, or that the only assets available to cover a given scenario do so at an unacceptably high cost. In other words, the quadrant should be used as a starting point for considering these scenarios and the potential responses to them, not a blueprint for creating a diversified portfolio.

  • 25 Don April 22, 2020, 3:48 pm

    The arrows in the graphic are labelled wrongly. Or am I going crazy?

  • 26 Chris F July 22, 2022, 9:56 am

    @Don – no not crazy, I came here to say the same thing ! The axis labels are swapped I think. Curiously I found an entirely unrelated pages that talks about the same four-way split, and their chart is flipped too (although in this one you have to flip the X axis to make sense of it : https://seekingalpha.com/article/4055785-framework-for-thinking-rising-inflation-think-function-not-form). Clearly some sort of conspiracy by big chart-makers to pull the wool over our eyes 😉

  • Mogul
    27 The Accumulator July 22, 2022, 11:49 am

    @ Chris – I think the ‘Inflation’ label should be where ‘Economic Growth’ is.

    But ‘Economic Growth’ needs to move one position clockwise to sit at 3 ‘o’ clock on the diagram.

    Then both labels would sit at the ‘high’ end of the scale.

    Make sense?

    Agree that the Military-Charting complex is up to no good 🙂

Leave a Comment