Many private investors struggle to get their heads around the concept of asset allocation, but it is the cornerstone of sensible investment.
One idea, courtesy of The Oblivious Investor, is to think of asset allocation in a similar way to the food pyramid that many of us learned at school.
The key here is that as a long-term investor you want to own more of the assets at the bottom of the pyramid and fewer of those at the top.
Specific percentages will depend on your age and risk tolerance.
For example:
- A young investor should have substantial long-term exposure to equities.
- A retired investor living off their income would typically have shifted a big chunk of their equity funds into cash, bonds, and even (whisper it!) annuities.
All very sensible, although if I could afford a Monet I’d be tempted to head to the top of the pyramid early.
Waterlillies are so much prettier to look at than the dealing screens of online brokers.
Be roughly right
Rules of thumb such as this pyramid are useful to get past the decision paralysis that can plague new investors.
It also helps to remember that the perfect asset allocation doesn’t exist. Asset allocation is as much art as science.
Even Nobel Prize-winning Harry Markowitz didn’t bother working out his own theoretically perfect portfolio, saying:
“I should have computed the historical co-variances of the asset classes and drawn an efficient frontier.”
But, he said, “I visualized my grief if the stock market went way up and I wasn’t in it — or if it went way down and I was completely in it.
So I split my contributions 50/50 between stocks and bonds.”
Markowitz’ focus on his tolerance for loss is also something for new investors to learn from.
If your equity allocation is above what your risk tolerance can handle in a stock market crash then you’re potentially heading for the rocks.
Selling out at the bottom of a bear market because you want to stop the pain could leave you stuck shopping at the Tesco Value baked beans end of the food pyramid in your old age.
Fine to go there when saving money for your financial freedom – but ideally you want to be able to get reckless in Waitrose once in a while when you retire!
Crikey, I would appear to be well overweight in bonds.
I subscribed to the John Bogle example of owning my age in fixed income securities. Despite selling a portion recently, I am not even close to your example.
No matter how much I have in the bank, I really can’t see myself ever going into the top tier. Certainly art and collectables are far too subjective for me.
I’m pretty much with Markowitz on this one. I understand the efficient frontier stuff, but can be bothered in practice. Also, I’m a bit of a fan of the bounded rationality/heuristic/decisions under uncertainty school of thought, so being super-precise in an uncertain world is inefficient.
Instead, the passive portfolio I run for my son is 60/40 stocks/bonds, with 5 ETFs in total. Takes about 10 minutes a year to run, at most.
Currently a little spooked with the Greek situation and the bond market. So having an article such as this helps in keeping one focused on the long term goal. Currently utilise Vanguard Lifestrategy 60/40 accumulation fund. what are the merits to moving to the 80/20 over the 60/40 fund? If one wanted to introduce property would Blackrock Global Property be suitable compared to property etfs? Apart from etfs are there any index funds for commodities available? I suspect we live in interesting times!
Thanks TI, a nice and interesting concept. It is clearly an ideal strategy for most, but IMHO not for all. A strategy like this helps protect against volatility (which is considered to be a risk for many people) and is diversified. However for some there will be other strategies that fit either as well or better, depending on risk profiles and their financial situation. For example someone with a sizable guaranteed final earnings pension may not need so much protection from volatility by holding so much in bonds.
Of course, as you say, the important thing is do something!
Ric
One tiny point about these allocation splits that has eluded me. Does holding shares in listed REITs count as real estate or equities?
“the food pyramid that many of us learned at school”: golly, you must be young.
@SG – REITs?
As you probably know, income from REITs is treated as property income for taxation purposes, not as dividends, so not equities on that basis.
SG, if it helps I think in terms of “Risk” assets and “Safe” assets. Safe assets are FSCS backed cash deposits, NS&I products, gilts and investment grade bonds. Everything else – equities, venture capital (even VC based on secured loans), REITs, preference shares, PIBS, etc. I treat as Risk assets because the capital is at risk. I don’t do P2P yet, but if I do at some point I would consider that as part of my Risk allocation.
Thanks TI. Another helpful article (although I don’t agree with the implication that there’s anything wrong with Tesco Value Beans!).
Following your epic recent bonds article, I was wondering whether you have done in-depth articles on 2 of the asset classes used as fixed income substitutes….namely REITs and infrastructure funds? I couldn’t find any using the search engine on the Monevator site and would love to read your thoughts on these…
@ The Escape Artist/The Investor
“Thanks TI……. I was wondering whether you have done in-depth articles on 2 of the asset classes used as fixed income substitutes….namely REITs and infrastructure funds?”
Yes would also be interested in views on these asset classes.
From our fixed income we should ideally hope for :-
+ve real yields
-ve correlation with stocks
Personally we don’t hold REITs but do hold some residential real estate, and the stock corrrelation here has varied substantially over time, sometimes +ve, sometimes -ve.
The real yields are presently 4%+ so that in the present investing environment is quite OK.
Also hold Infrastructure Funds HICL and 3IN as fixed income substitutes. We do not kid ourselves however that these may not become +vely corrrelated with stocks as happened in 2008/9 to 3IN and to a lesser extent to HICL. So a goodly chunk of cash is also held for such an eventuality, as the proverbial dry powder.
The only gilts we now hold are through index linked fund INXG.
Cannot bring ourselves to go back into nominals until real yields turn +ve (assuming inflation by end year in range 2.25% to 2.75%).
It would be a disaster on top of the -ve real yields if the nominal gilts’ usual negative correlation with stocks failed to show up.
So yes, these are interesting asset classes and worthy of further discussion, I.E. if not already covered.
@Custodian — This is really just an illustrative pyramid, I wouldn’t take it as a reason to question any particular allocation you’ve made. As you probably know we’ve written many more detailed articles about asset allocations including on the topic of how much to hold in bonds. Besides using the Search Bar (top right) you might try this one, for instance:
http://monevator.com/asset-allocation-types/
@MyRichFuture — I think an allocation of gold is justifiable, but otherwise agree from an investment perspective. That said if you’re wealthy and have money to spare, I do think buying assets for your life/home that happen to have the capacity to hold or increase in value — and that you like for their own sake (e.g. antique furniture, art) — is worth consideration.
@UKValueInvestor — At least once a month I try to explain to someone (someone who usually has a technical/engineering background) that there is no knowable perfect asset allocation, except in hindsight. A certain kind of person finds that very hard to accept!
@William — The merits of holding the 60/40 over the long-term versus a more equity heavy LifeStrategy fund is you’ll likely suffer less volatility over the short to medium term, but lower returns over the long term. It may well be a trade-off worth making, depending on your risk tolerance. As said above, we’ll only know for sure in hindsight. 🙂
@Ric — Well, as said above it’s really just illustrative not a proscribed allocation. (The equity component alone in the illustration varies from 40-80%, which is quite a range!)
Fair points on individual situations. I will say though that whenever I hear people describing why they don’t feel the need to own X or Y because of their special circumstances, they’re almost invariably making the case for owning more equities. I like to monitor this sort of sentiment as an indication of stock market peakiness! 😉
It’s worth remembering the very rich often diversify very widely:
http://monevator.com/preservation-of-wealth/
@SG @Topman @Naeclue — Many (most) UK REITs hold baskets of equities (which in turn hold underlying property). They are definitely correlated with equities, though I don’t have the exact data to hand. From memory there have been definite diversification benefits though in the past, and decent almost equity-like returns.
Not surprising really, as they invariably own commercial property which is let to companies; in an economic cycle their fortunes will be tied to those sorts of companies plus the interest rate cycle, but with (in the better cases) improved asset quality (because they own property!)
Sorry, this is probably all a bit wooly and you could do with a snappy sort of snappy passive focused answer! 🙂 In as much as REITS are definitely not bonds, then I’d consider your allocation to them as coming from the equity portion of, say, a classic 60/40 equity/bond portfolio.
@TEA @Magneto — I don’t think we’ve done much specific in the past, on infrastructure at all. I think both TA and I consider it a bit faddish and expensive (well, he more faddish and me more expensive). I don’t think there’s anything wrong with it per se, but I don’t think it’s a different asset class, especially at the level at which we private investors are playing. (i.e. via funds / listed access). Different perhaps if you’re a massive pension fund taking direct ownership of a bridge.
As for REITs, not anything specifically passive (although it’s been mentioned in all TA’s passive allocation articles, with suggested funds in some cases).
I’ve done a bit on commercial property such as British Land, Land Securities etc over the years (which as you know are REITs) but that was from a more active angle.
This is probably the closest we’ve come to an all-round article — it’s only short:
http://monevator.com/commercial-property-asset/
@Naeclue I’m with you except even the best investment grade bonds fall into my credit allocation as ‘risk’ assets.
Remember the fun and games AIG had after harvesting the apparent free lunch from writing ‘risk-free’ CDS insurance on super-senior AAA+ rated credit?
Being (relatively) young, I keep my emergency fund in a combination of NS&I RPI-linked savings and FSCS-protected deposits. I also consider gilts held to maturity to be ‘risk-free’ in this sense (but it’s an academic point for me anyway, as despite forming part of my strategic allocation, my lizard brain is still screaming “bubble” so I’m tactically avoiding the return-free risk of gilts. For now). Everything else…risk on!
I hold 6 to 12 year gilts, each January, when I rebalance my portfolio, I sell the shortest dated gilt and buy a 12-13 year gilt. Whether I do that next January remains to be seen. 1-3 year cash deposits are now relatively more attractive. Not only will we be able to earn £1,000 interest free of income tax, but we can move money from S&S ISAs to cash ISAs, although there are often annoying restrictions and the ISA cash rates are often not the best on offer.
I hate taking a view on things as more often than not my opinions turn out to be wrong, e.g. who would have guessed that US equities would have returned 20% last year after returning 30% the year before and from already high valuation metrics? BUT, at the moment, the return I would get by rolling over 1-2 year deposits for 7 years looks better than the return I would get by holding a 12 year gilt for 7 years. I calculate that it would require negative 5 year gilt yields in 7 years time for this not to be the case. If it still looks that way in January I will most likely go for deposits.
Naeclue, all: do you hold your gilts in tax sheltered accounts? Is there an ‘optimum’ way to spread different asset classes between ISA, SIPP and taxable accounts?
I have about half our investment portfolio in taxable accounts. Whenever I’ve wondered about whether to place certain assets (bonds, higher yielding equities, small caps) into specific types of account, I end up concluding that it probably doesn’t make much difference, so each type of account has ended up with broadly similar asset allocation…
Vf: do you pay higher rate tax?
@edge of cultivation — Hi, you write:
This is factually incorrect. The UK ten-year gilt is offering a yield of around 2%, which is above the rate of inflation. So there’s a positive return on offer, if not a very large one. (Of course you might believe inflation is going to rise a lot for some reason, but that’s another issue. 🙂 )
@ William – yes, BlackRock’s Global Property Securities index fund is a fine alternative to global property ETFs.
Lots of commodity related index products available – generally called ETCs. Highly controversial topic among passive investors. Very hard to find a product that actually gives you good exposure to the underlying properties of the asset class, that can’t be gamed by the market and that will actually do you many favours in a wide-range of economic climates.
Gold ETFs that actually hold the stuff wouldn’t fit the above description, but you’d hold them for different reasons than broad-based commodity trackers.
@ Escape – REITs and infrastructure funds are not fixed income substitutes. People who are stretching for yield may be turning to them in the face of dismal returns on bonds but they are more volatile and unlikely to be what you want propping up your portfolio when the economy turns south. They belong in the risky portion of your portfolio.
@TA – “REITS ….. belong in the risky portion of your portfolio.”
What about mainstream ITs i.e. Foreign and Colonial, City of London et al, which are quasi-fixed income?
@Topman — Do you mean City of London investment trust, etc? That’s risk risk risk. It shouldn’t be thought of as coming out of the fixed income allocation of a portfolio at all.
Such an income trust *might* be used as a fixed income substitute by a yield-hungry somebody who wants *income*, IF they decide they can ignore/live with the greatly increased volatility in the capital value and the potential for chops and changes in the income the trust pays out.
It does not at all substitute for the risk/reward profile of fixed income though.
Try these articles for starters:
http://monevator.com/shares-deliver-the-best-long-term-returns-so-why-invest-in-bonds/
http://monevator.com/cash-bonds-different/
@TI
These days I’m only drawing one small occupational pension and one minuscule annuity, plus the state pension, but I have c.400k diversified amongst long run, steady state income (withstood 2008/9) ITs, where the “potential for chops and changes in the income”, such as it is, is well within my tolerance.
As for “volatility in the capital value”, bring it on either way. A fall and I bump up my holdings “on the cheap”, a rise and who knows it could stretch to a Bentley ~:-) !
@Topman — Good stuff, sounds like you’re sorted. 🙂 I love equities and I also like income trusts, but neither my fetish for shares nor the nice position you’ve put yourself in stops them being risk assets. 🙂
Congrats on your success — what we’re all aiming for here!
@The Investor
No, it is correct. Expected return is negative, and comes with a pair of nasty risks to boot.
The Bank of England yield curves at http://www.bankofengland.co.uk/statistics/pages/yieldcurve/default.aspx give you the relevant data.
Let’s take 26 June (the most recent available date) as an example. Spot yield on 10y gilts were 2.30% (i.e. the nominal yield you’d receive if you bought and held a gilt with exactly 10y left to run on that date, ignoring any transaction costs and taxes).
Index-linked gilts of the same duration are yielding *minus* 0.68%. You can either use the formula: (1+nominal yield)/(1+real yield) = (1+inflation) or look at the implied inflation curve to see that market expectations of average inflation over the next 10 years is running at (1+2.30%)/(1-0.68%)-1=2.99%, much higher than the current annual CPI *print* which is hovering around zero. I’ve seen estimates of the RPI-CPI wedge of 0.5%-0.75% meaning RPI runs typically that much higher than CPI.
So if yields and inflation follow the path currently anticipated by the bond markets, you will lose 0.68% pa in real terms by holding a 10y gilt.
However, you are running two risks:
1. RPI inflation out-turn is higher than expected, further eroding the value of your bond. The flip side to this is that if RPI remains lower for longer then your realised real return will increase.
2. Nominal yields rise faster than currently expected eroding the market value of your bond.
@edge — All fair enough. However you wrote “return free risk” in your initial comment not “real return free risk”. That was what I was initially responding to.
I obviously have no argument with anyone thinking in real return terms, but as you know yields (including even interest on cash deposits) are typically quoted in nominal terms, so if you happen to be talking in real terms I think it’s best to state it.
Clearly you understand all this in light of your follow-up comment, but I answer dozens of comments a day and can’t assume anything when I do. 🙂
@The Investor
“so if you happen to be talking in real terms I think it’s best to state it.”
Oops. Zero marks for not showing my working. 😉