One of the most fun things about managing your own investments is coming up with an asset allocation strategy to diversify your portfolio. It’s a chance to tinker like an alchemist to find that blend of asset classes that’s going to help you weather the financial storms ahead, and see you dancing upon the sunlit plains of financial independence some time yonder.
So what are the asset classes that make suitable straw for your passive investing nest?
In the rest of this post, I’ll highlight the pros and cons of the main asset classes.
This will be familiar stuff to many Monevator readers, but it’s always useful to have a frame of reference, especially as the investing world can rarely agree on a consistent definition for anything.
Cash
Filthy lucre, spondoolicks, the root of all evil… We’re all familiar with money, though perhaps not as much as we’d like to be. The simplicity and familiarity of cash is one of its biggest advantages, but excessive devotion to it can be the undoing of the cautious investor.
Good
- You can’t suffer a capital loss.
- It’s liquid like water. If you lose your job and need some food or rent, your cash reserves can quickly be converted to satisfy whatever need is at hand.
Bad
- Cash will be clobbered by inflation over time. £100 will only be worth £74.41 in 10 years, if the ongoing inflation rate matches the historical average of around 3%. 20 years down the same timeline and £100 will only be worth £55.37.
- Historically, cash has earned the lowest returns of the major asset classes.
Risk/Reward trade-off1
- Risk = Low
- Reward = Low
Time horizon
Cash is useful over any time frame, but you are likely to get poor slowly if you hold excessive amounts over the long term. Spicier investment options are needed to achieve most financial goals.
More on cash
Bonds
Bonds are I.O.U.s issued by an entity such as a company or government. In exchange for your loan, the bond issuer will pay you a guaranteed stream of interest over the loan period, plus you’ll get your original stake back after an agreed number of years. (Unless the issuer does a Greece and defaults, that is).
Passive investors should only concern themselves with investment-grade bonds, and there are strong arguments to restrict your portfolio allocation solely to domestic government bonds.
Good
- Government bonds are much less volatile than equities.
- Historically, they’ve provided a better return than cash.
- A lack of correlation with equities makes government bonds a useful way to protect your portfolio against stock market crashes.
Bad
- Bond returns historically lag equities.
- They are vulnerable to inflation (unless you choose index-linked varieties) and changes in interest rates.
- Many investors struggle to understand bonds.
Risk/Reward trade-off
- Risk = Lower than equities, higher than cash
- Reward = Lower than equities, higher than cash
Time horizon
You can match your bond holdings to any time horizon and know exactly what your return will be, if you hold the bonds until maturity.
Sub-classes2
- Government bonds i.e. UK gilts, US Treasuries
- Corporate bonds
- Inflation-protected bonds i.e. index-linked gilts, TIPS
- Local government bonds
- Junk bonds i.e. high-risk bonds with terrible credit ratings
More on bonds
Equities
Equities (commonly known as stocks or shares) are historically the riskiest and best rewarded of our main asset classes.
That relationship is writ in stone by the laws of finance. Because equities are so risky, investors demand high potential rewards to play the game. Note that word: potential. There is no guarantee that equities will deliver; they do not provide a guarantee of income or capital. Instead, they offer part-ownership of a company and thus a claim on its future earnings.
Good
- Equities have traditionally outgunned every other asset class when it comes to long-term returns. They are the most powerful asset class in your diversified portfolio.
- Equities are capable of outstripping inflation. They’ve historically delivered a return of 5% after inflation, in the UK.
- The longer you hold equities, the better your chance of achieving your financial goals.
Bad
- Severe losses can occur at any time and frequently do. You could easily lose 30% of your capital in a single year.
- Losses can be very long-lasting. Japan is the textbook example of a market that’s failed to recover its value in over 20-years.
- The highs and lows of equity ownership can feed all kinds of irrational behaviour, from panic-selling in the face of loss to piling into a bubble market. Fear and greed rule.
Risk/Reward trade-off
- Risk = Higher than bonds, property or cash
- Reward = Higher than bonds, property or cash
Time horizon
The longer you can hold the better. Five years is the bare minimum, 20 years is a more comfortable stretch.
Sub-classes
- Capitalisation e.g. Large cap, small cap
- Style e.g. Growth, value
- Geography e.g. Domestic, emerging markets, international
- Sector e.g. Technology, utilities, consumer staples
More on equities
Property
As an investment asset class, property (or real estate) refers to commercial property that delivers returns in the shape of rent and the appreciation of building values. It doesn’t refer to your house.
Exposure to commercial property is generally achieved through real-estate investment trusts (REITS) or ETFs. Sticking all your money in a ‘buy-to-let’ concentrates rather than diversifies your holdings and is taking a big punt on the everlasting strength of the UK property market.
Good
- Historically, the risk and rewards of property have been a halfway house between equities and bonds.
- It can be a useful diversifier, as global property returns have demonstrated a moderately low correlation to UK equity.
- Property is also likely to keep pace with the rate of inflation.
Bad
- Property bubbles can pop and inflict large losses on funds.
- Property is illiquid, which can lead to funds imposing exit restrictions on investors during periods of market stress. In other words, they can’t sell their buildings quickly if everyone wants their money back at the double.
- UK investors tend to have a rose-tinted view of property due to the strength of the home market over the last 20 years. However the asset class has historically lagged equities.
Risk/Reward trade-off
- Risk = Higher than bonds or cash, but lower than equities
- Reward = Higher than bonds or cash, but lower than equities
Time horizon
As per equities.
More on property
Commodities
Investing in commodities is the business of speculating on the price of cows, or oil or gold. You are betting that the future price of the asset will be higher than the current price.
However, there are very few opportunities for ordinary investors to bet directly on that spot market price because few of us can actually store several million barrels of oil.
With the exception of some precious metals like gold, a regular Joe’s only option is to invest in commodity funds that provide exposure to the price movements of commodity future contracts3.
Commodity future funds thus don’t make their money from the onward march of the spot price but by trading futures and earning interest on collateral.
Good
- Low correlation with equities may reduce portfolio risk.
- Gold is negatively correlated with equities.
- A good inflation hedge.
Bad
- No long-term source of reward for direct commodity exposure. Commodities don’t pay dividends and future returns should equal inflation.
- There is no clear evidence that investors can expect a long-term return from commodities futures either.
- The workings of commodity future funds are extremely complicated.
Risk/Reward trade-off
- Risk = Equivalent to Large Cap US equity.
- Reward = Inconsistent and hotly debated. Better thought of as a method to reduce the risk of equities.
Time horizon
Commodities should be thought of purely as an equity diversifier and therefore held for a similar timeframe (if at all).
Sub-classes
- Energy e.g. oil, gas, petrol, heating oil
- Agriculture e.g. wheat, corn, soybeans, cotton, sugar, coffee, cocoa
- Industrial metals e.g. aluminium, copper, nickel, lead, zinc
- Livestock e.g. live cattle, feeder cattle, lean hogs
- Precious metals e.g. silver, gold
More on commodities
Alternative asset classes
Other asset classes exist, of course. You’ll no doubt have heard tales of the killings to be made in:
- Hedge funds
- Private equity
- Currencies
- Volatility e.g. the ‘Fear index’
- Collectibles e.g. art, wine, cars
A passive investor wades into these waters at their peril. Most alternative asset classes can be discounted on some or all of the following grounds:
- Their role in a diversified portfolio is highly questionable.
- They suffer from high costs, or illiquidity, or other barriers to entry/exit.
- A high degree of expertise is required to avoid being spanked by other players in the market.
- Their track record is murky at best.
The bottom line is that any investor can construct a highly diversified portfolio from the main asset classes: cash, bonds, equities and property, and also stirring in commodities if you’re truly convinced by its merits.
Take it steady,
The Accumulator
- Note, this is the expected trade-off based upon the historical returns of each asset class. Actual risks and returns can turn out very differently. [↩]
- This isn’t an exhaustive list, just a quick run-down of the more common varieties. [↩]
- An agreement to buy or sell a commodity at a particular price, at a set date in the future. [↩]
Interesting comments on commodities. I set up some passive investments along the lines of Tim Hale’s book and bought some exposure to commodities (a Lyxor ETF) without really thinking about how it tracks the market. Your comments seem to suggest I might not need any in my portfolio (though I’d be loathe to sell at the moment as they’re being spanked along with equities by Greece). Anyone else have any thoughts on the long term return from commodities?
I’m surprised you don’t devote more time to bonds that promise to beat inflation over a time period, e.g. index linked government securities, NS&I linkers, some corporate bonds
Granted its a small field of investable assets, but these products (to a varying degree) deliver a big part of what an investor wants: predictable returns guaranteed to enhance the value of their savings after inflation
Nothing else does that; property, equities and commodities might but equally might not
Note: the Bank of England pension scheme is invested only in index linked gilts…
@ Ash G – I keep flirting with commodities but can’t bring myself to take the plunge because the advice/evidence is conflicting and the product mechanisms are opaque. However, if you plot the performance of a broad-based fund like the (deep breath) Lyxor ETF Commodities Thomson Reuters/Jefferies CRB TR versus a FTSE tracker then you can clearly see the lack of correlation. Theoretically that enables you to up your allocation to riskier investments without increasing the overall risk in your portfolio. I certainly wouldn’t allocate more than 5-10% of my portfolio to commodities though, as a diversifier, but as I say, in reality I’m allocating 0%. As to the chances of long-term return, William Bernstein described commodities as the ‘asset class de jour’. In other words, once everyone’s piled in already, what are the chances that there’s much gain still left on the table?
@ Neverland – agreed, index-linked gilts do deserve more airtime, though I think The Investor has written a few times about NS&I Certificates. Personally, my portfolio is positioned so that equities are providing my inflation-proofing, and I sure need the returns I hope equities can provide over linkers. That will change as I wrinkle of course.
@Ash G — I personally prefer to get commodity exposure through producing companies, though I can see the case for a holding of precious metals, specifically gold. The last decade or so is unusual — commodity *prices* have gone nowhere or even gotten cheaper over the longer term, due to human ingenuity. (See this famous wager). That said smarter minds have reached different conclusions (as well as the same conclusion…) hence one for personal choice I suspect. If you believe in a coming resource shock / special few decades due to population growth/rampant expansion, maybe the case is stronger. (I don’t, particularly).
@Neverland — They are mentioned under ‘bonds’. That is where they sit within the asset classes. NS&I certs are great, as I mentioned the other day and have said before I’d buy them whenever they’re on offer. Alas currently they’re not.
Last I looked inflation-linked gilts were *not* guaranteed to provide a return that would enhance your savings, because such was the crazy demand in these bear-maniac times that the real-return was implied to be negative. Here’s a source:
I’m not saying they don’t have a place in portfolios, even at these elevated prices, though personally I have none (but do have a fair slug of NS&I inflation linked certs). I do think it’s a bit late to get too enthusiastic about them, however.
Cheers both for your thoughts.
I feel commodities have offered a reasonable rate of return, but it seems there is a lot of academic debate as to why. It is far more obvious why bonds, gilts and shares do.
I would rather overpay my mortgage!
@TheAccumulator – “Personally, my portfolio is positioned so that equities are providing my inflation-proofing, and I sure need the returns I hope equities can provide over linkers. That will change as I wrinkle of course.”
Tbh, it also factors with cash since you can move cash within an ISA into the best of a set interest rate or inflation without taking it out an ISA; there’s always overlapping between classes. Property, for example, can be held in an investment fund and then you lose some benefits from some gains etc, so I think The Investor is right in saying they are already there, it just depends in what form you take them. In some forms inflation-backed bonds are like cash, in others they are more risky, say Greek inflation-backed bonds.
1. Thanks, as ever, for this.
2. You say William Bernstein “described commodities as the ‘asset class de jour’”. When, exactly, did he say this? Was he referring to ‘now’?
3. Anyway, what does it really mean? Does he deem commodities to be too ‘expensive’? If so, I thought we’re not trying to time entry…
Hi Alex, Bernstein said that in his book The Investor’s Manifesto: Preparing for Prosperity, Armageddon, and Everything in Between. It’s a couple of years old now, but I don’t think there’s been a bolt out of commodities since then. I think he does mean that commodities are expensive, though that’s not his only reason for not liking them. If you’re buying commodities because you’re hoping to make a big return then I think it’s worth knowing. You probably aren’t going to make a killing on gold now. However, if you’re holding to protect yourself against certain financial risks then that’s a different matter.
I know much has been said about the conventional strategy of passive investing, which is to pick your asset classes according to correlations, rebalance often, and stick to your allocations, whatever the market does.
However, what if the correlation between asset classes constantly changes, as it does now? Surely we lose the benefits of diversification and incur more risk then.
Perhaps Adaptive Asset Allocation, which rebalances portfolios according to recent asset correlations (as opposed to historical correlations) could be the answer? A paper was written about this in 2010 by Sharpe, who worked on the Modern Portfolio Theory which so many of us here follow, so this strategy must bear some merit.
Here’s a link to a good write up on Adaptive Asset Allocation. Any thoughts?
http://seekingalpha.com/article/587491-adaptive-asset-allocation-a-true-revolution-in-portfolio-management
There’s actually a 4 part series of posts where the one Matthew linked to is the last one. It looks interesting but I don’t know how you’d put it in to practice. Maybe they’re going to launch a fund…
Here’s the first article with links to the others
http://advisorperspectives.com/dshort/guest/BP-120507-How-to-Beat-the-Market.php
The Adapative Asset Allocation theory is pretty interesting, and as you say it has a great pedigree coming from Sharpe.
However without proclaiming to be an expert or wanting to argue with a Nobel Laureate, a few potential problems do stick out, especially for private investors.
First, as you say, how do you implement it? The data requirements are well beyond the average investor. Secondly, I see no talk of costs, although in principle I suppose these may be no different from conventional asset allocation that is rebalanced very frequently. Third, the underpinnings are complicated – I haven’t studied it in detail, but in general it’s hard to stick with a strategy you don’t fully understand. Fourth, I’m a bit sceptical of data mining in general, and especially at an unusual time like this (potentially end of bond bull market in next 1-3 year, say) as an encouragement into a new strategy, though of course that’s not the only justification given here.
Finally, and most importantly, Sharpe’s original criticism as I recall seemed to be that “not everyone is a contrarian”. Traditional asset allocation and rebalancing requires you to sell winners and buy losers; this is a way around that, to some extent. You would expect there to be a price to pay in terms of lower returns, and I would understand if the strategy was being touted as ‘less pain less gain;. Yet this article is suggesting you can have lower maximum daily drawdown AND higher returns. That seems counter-intuitive.
Not knocking the thirst for knowledge, but those are my initial thoughts.
I love your emails, Monevator, but (a) I think it should be “spondulix” not “spondoolicks”, although that is only a slang term for money anyway, and (b) come on, money really is supposed to be the ROOT of all evil, not the ROUTE of all evil! (And it isn’t money anyway, it’s the LOVE of money that is the root of all evil!)
This just in from Wikipedia:
Spondulix, spondulicks, spondoolicks, spondulacks, and spondulics are alternative spellings of spondoolies.
I’ve never seen spondulix before nor had cause to look up the origin of the word, so cheers, that was fun!
Don’t understand your route reference though, much as it would make a good pun for a story about Britain’s next runway.
@T.A. — Graham’s reference to route was an misspelling in the post that survived both your authorship and my initial editing. I changed it to root on reading and uploading his feedback, but I left the spondoolies for you to opine on.
Good opining!
Good overview of assent allocation and views.
Bonds.
I was wondering what your thoughts are on retail bonds (Order Book for Retail bonds).
These can be bought on issue and held to redemption (assuming compatible with your investing timeframes). You get back the capital sum (if held to redemption) and the coupon as you go along.
You need to have some confidence on survivorship of the issuing company and that the interest/coupon will be adequate over the life of the bond. Also tradable. Higher risk than ordinary bonds?
Thanks
@TA,
You don’t mention P2P in any of it’s guises – I’m not batting for or against it …..& do understand that there may be overlap with some other asset classes, (lending to small businesses is arguably not different to a mini-bond) but would be interested in your opinion/analysis.
I thought it could warrant a separate class of investment on it’s own & was curious as to where you would place it on the risk/reward graph relative to the other classes generally?
Though maybe only as a niche feature, I think P2P will be a permanent feature of the investment landscape from now on, if only because the returns elsewhere are so disappointing.
@TA…ha ! Disagree that’s the fun of it, wish I could just set up and leave until retirement… Had even been considering talking to an advisor but although an advisor could take a holistic view of my situation I’m not sure why (s)he’d be any better at determining the age old how much of each class to hold at each stage…
@TI just starting to read the corporate bonds posts you did in 2009… Currently set up to do some gilts, some inflation gilts some bonds but I’ll see how I feel after ;0)
@Survivor… I’m not going to touch P2P… The closest comparable asset appears to be buying bonds in tiny companies or investing in tiny companies ? In that way to my inexperienced mind its not diversifying out of equities…rather loading up on the riskiest end ? Please correct me if I’ve got this wrong
P2P sounds to me to be rather like high yielding bonds. Consumable commodities would behave (I guess) like equities over a long enough term, perhaps with a lead or lag.
Gold isn’t consumed, so it might indeed be a diversifier.
Commercial property: I wouldn’t buy it in an open-ended fund. Perhaps in a REIT?
Good overview of the assets classes.
In the commodity space, I limit myself to gold. And I use it more as a safe heaven in case of troubles. that is why I build up my position only since last year, when I thought the European crisis would start with the Greek crisis. I was wrong… I never the less keep it in portfolio, just in case.
P2P are like junk bonds but with an additional insurance policy purchased on top to cover *expected* defaults.
I wonder if michael milken is getting excited about them?
@ Planting Acorns, yes you’re right specifically with respect ‘lending to small businesses’ P2P, well described, I hadn’t thought of it like that – & as it’ll therefore act in parallel to stocks in recessions, it’s not even a hedge. This category is exploding with creativity though & individuals lending to businesses is only one model – there seems to be something new every month, so maybe something better will evolve.
@Dearieme, I guess some P2P might be like high-yielding bonds, it depends if those bonds are asset backed & inflation indexed though – horses for courses – like everything else, the key is to really understand the risk with each investment instrument & then make sure it’s within your tolerance range……..
@ All, Physical cash may become a problem in these zero-interest times, if the banks start restricting access so we can’t keep it ‘under mattresses’ to escape effectively paying them to hold it &/or capital controls [for ‘security reasons’ of course – hence usefully, no explanation possible] as is still in place in Greece today.
On P2P, I think high-yielding bonds are indeed the obvious comparison point. (Not high interest savings accounts, whatever the advertising might suggest!)
However, P2P does potentially offer diversification. Last time I looked, the different platforms broke down as follows:
Funding Knight – small business
Zopa – personal loans
Funding Circle – small business
Thin Cats – small business
LendLoanInvest – personal
MarketInvoice – small business (factoring)
LendingWorks – personal
LandBay – buy to let
LendInvest – property (residential and commercial)
Assetz – small business, property development, buy to let
Ratesetter – personal, small business
The lack of transparency strikes me as a bit offputting (you need to dig a little, so it seems that investors are not really meant to evaluate P2P in these terms) but if you are prepared to do a fairly minimal amount of research then you can ensure both that your P2P is a diversifier when compared to your other assets and also, by spreading between different platforms with different borrower bases, that your P2P portfolio is itself diversified. (Whether the risk is right for you and whether it matches the rewards on offer are, of course, separate questions!)
With regards to physical cash, there have been a few articles recently about moves to withdraw high denomination notes. The highest in the UK is only £50, but I was surprised to hear that the Swiss have a 10,000 franc note (worth over £700). Less surprisingly, the Swiss are hanging on to it. Now that would buy a lot of chocolate! (And no need to tell the taxman.)
Technically speaking its actually £100 million or a ‘titan’. You wouldn’t have to jam too many of them under your mattress to get the desired effect..
“The highest in the UK is only £50”: £100 in Scotland and N.I.
Interesting discussion, if a bit OT for this article. 🙂 think I will do an article about these alternative cash-like-slash-replacement-sort-of options soon. They do offer something different, and possibly ultimately unattractive from a risk/reward basis — the data is still short, of course, as they haven’t been around a long time. I’d see them more fitting into my kind of menagerie approach to portfolio construction than @TA’s pure passive approach (and indeed I’ve dabbled in all).
I don’t think any of the comparisons are 100% accurate (e.g. You don’t have the liquidity with some P2P and with mini-bonds that you do with conventional corporate bonds or ORB issues, say, it’s harder to diversify and so forth) but that’s equally why we can say they offer something different.
I do wonder with P2P if they have been passed through some investment banks research dept to see if they are sensibly priced and thus whether they represent a new ‘opportunity’ as it were.
Since I rebalanced last have been watching how various bond funds react to equity market swings. Currently holding SLXX (investment grade Corporate Bonds), IGLT (UK govt bonds) a couple of strategic bond funds. So far the lack of yield on gilts is more than made up for by the negative correlation with stocks on down days, but more curious how the long term total return compares. Could you get away with all or the bulk of your bond quota in IGLT without harming long term returns due to the overall safe haven effect on your portfolio in times of extreme stress?
My other observation is the Woodford Equity Income fund – a rare active fund in my portfolio -, has done incredibly well and behaved more like a bond fund as the main markets have tanked over the last year. Can’t begrudge the fees on that one so far.