I hope you’re enjoying these good times as an investor. 2017 was another pain-free 12 months for our Slow & Steady passive portfolio. We ended 9% up on the year.

Coming in the wake of that monster 25% bunk-up in 2016, checking the numbers all year was a soothing ego-balm – about as mentally challenging as telling your mum you got a promotion, or handing over a Christmas present to a child.

The bulls have owned the global stock markets like the streets of Pamplona. It was the kind of year that makes us all look like investing geniuses, as the portfolio numbers below show (brought to you by G-Whiz spreadsheet-o-vision):

• The portfolio is up 52% since we started seven years ago.
• That’s 10.92% annualised, or around 8.5% in real ¹ terms. The historic real return of an equity portfolio hovers right around the 5% mark, so we’re living through a blessed time, believe it or not. (All the more so as we’re laden with sluggish bonds, too.)
• Emerging Markets was the star performer: up 21% this year.
• The FTSE All Share contributed 13.35%, with the FTSE 100 global behemoths larging it up on a weak pound.
• Our biggest holding – the Developed World ex-UK – brought in a similarly welcome 11.39%, with Europe and Japan scoring a rare victory over the US (which nevertheless hit new highs during the year).

With equities looking flush, it’s no surprise that our annual bond gains pale by comparison:

• UK inflation-linked bonds – 2.24% higher.

• UK Government bonds (conventional gilts) – up 1.64%.

These are nominal returns. Our fixed income assets have actually lost value after inflation.

The Slow and Steady portfolio is Monevator’s model passive investing portfolio. It was set up at the start of 2011 with £3,000 and an extra £935 is invested every quarter into a diversified set of index funds, tilted towards equities. You can read the origin story and catch up on all the previous passive portfolio posts.

But we should never get hung up on recent performance. Our longer term returns tell a slightly different story. Over seven years:

• The Developed World is the clear leader, up a staggering 15.5% annualised.
• Emerging Markets delivered near 10% annualised, but at the cost of some fearsome volatility along the way.
• We’ve only owned Global Small Cap for the last three years but it’s brought home a handsome 16.82% annualised.
• Global property has brought in 9% annualised over three years; it failed to keep pace with inflation with an insipid 2% this last year.
• Conventional government bonds have delivered 5% annualised over the full period – so around 2% to 2.5% ahead of inflation. A good performance by historical standards.

We’ve had a great run, with the portfolio working like the textbook example it’s meant to be:

• Equities are powering up our wealth.
• Government bonds are a handy diversifier, but they’re lagging over the longer term.
• Emerging Markets are hugely volatile and often diverge from the Developed World.
• The US market shows that a single market can trounce all-comers for a decade or more. As we can’t predict which market will win, we stay diversified.

Portfolio maintenance

It’s portfolio MOT time! With every stock market around the world steaming ahead, it’s an auspicious moment to reduce our exposure by moving 2% of our wealth away from equities and into government bonds.

We’re not doing this on a whim, though. We’re simply following the risk management tactic we committed to when we set up the portfolio, redeploying into less volatile bonds in 2% steps every year.

With 13-years left on this model portfolio’s investing clock, we’re now 66/34 in equities versus bonds. The plan is for our allocation to be 40/60 equities versus bonds by the end. We should be well insulated from a sudden stock market crash by that point.

As it is, the US market is richly valued, so I’m more than happy to snip back the Developed World fund by 2% (it’s over 50% invested in the US). That 2% shifts into the UK Government Bond fund. We’ll likely be very glad about that should markets dive in 2018.

We could have made marginal cuts to our other equity positions instead – Global Small Cap, Emerging Markets, the UK’s FTSE All-Share or Global Property – but we left them alone to maintain a healthy level of diversification across asset classes.

Our 2% asset allocation shift also merges into our annual rebalancing move. Every year we rebalance the portfolio back to its preset target asset allocation. Again this is about risk management, as we cream off the profits from assets that have soared in value and plough the proceeds into cheaper markets whose time should come again.

This quarter it means selling a chunk of Emerging Markets and Developed World and scooping up UK Government Bonds and a few Inflation-Linked Bonds in exchange.

Remember, we’re not making a judgement call. We’re just staying in line with the asset allocation we have set.

Increasing our quarterly savings

Now to deal with inflation. The sharp-toothed money nibbler has bitten off 3.9% this year according to the latest Office for National Statistics’ RPI inflation report.

To maintain the value of our contributions, we must therefore ‘inflate’ our own quarterly investments from £900 in 2017 pounds to £935 in 2018 wonga.

We’ll do that every quarter in 2018, although we’re only putting in £931.73 this time. Why? Because the rebalancing rejiggery equals a £3.27 contribution to Global Small Cap. That’s under our platform’s £50 minimum investment limit, so we’ve written it off for the sake of convenience.

Here’s this quarter’s buy and sell:

UK equity

Vanguard FTSE UK All-Share Index Trust – OCF 0.08%

Fund identifier: GB00B3X7QG63

Rebalancing sale: £20.78

Sell 0.102 units @ £203.88

Target allocation: 6%

Developed world ex-UK equities

Vanguard FTSE Developed World ex-UK Equity Index Fund – OCF 0.15%

Fund identifier: GB00B59G4Q73

Rebalancing sale: £881.44

Sell 2.674 units @ £329.60

Target allocation: 36%

Global small cap equities

Vanguard Global Small-Cap Index Fund – OCF 0.38%

Fund identifier: IE00B3X1NT05

New purchase: £0 (Leaves fund pretty much bang on 7% target allocation)

Target allocation: 7%

Emerging market equities

iShares Emerging Markets Equity Index Fund D – OCF 0.25%

Fund identifier: GB00B84DY642

Rebalancing sale: £285.94

Sell 175.964 units @ £1.63

Target allocation: 10%

Global property

iShares Global Property Securities Equity Index Fund D – OCF 0.21%

Fund identifier: GB00B5BFJG71

New purchase: £245.78

Buy 124.697 units @ £1.97

Target allocation: 7%

UK gilts

Vanguard UK Government Bond Index – OCF 0.15%

Fund identifier: IE00B1S75374

New purchase: £1674.16

Buy 10.28 units @ £162.86

Target allocation: 28%

UK index-linked gilts

Vanguard UK Inflation-Linked Gilt Index Fund – OCF 0.15%

Fund identifier: GB00B45Q9038

New purchase: £199.95

Buy 1.059 units @ £188.79

Target allocation: 6%

New investment = £931.73

Trading cost = £0

Platform fee = 0.25% per annum.

This model portfolio is notionally held with Charles Stanley Direct. You can use that company’s monthly investment option to invest from £50 per fund. Just cancel the option after you’ve traded if you don’t want to make the same investment next month.

Take a look at our online broker table or tool for other good platform options. Look at flat fee brokers if your ISA portfolio is worth substantially more than £25,000. The Slow & Steady portfolio is now worth over £38,000 but the fee saving isn’t yet juicy enough for us to push the button on the move yet.

Average portfolio OCF = 0.17%

If all this seems too much like hard work then you can buy a diversified portfolio using an all-in-one fund such as Vanguard’s LifeStrategy series.

Take it steady,
The Accumulator

1. That is, after-inflation[↩]

What caught my eye this week.

I agree with Merryn Somerset-Web, who writes in the Financial Times this weekend that:

I’m concerned – and hardly alone in being concerned – about the bad rap capitalism is getting at the moment.

Despite pretty definitive proof that free markets are the best way to make the world richer, healthier and happier over the long term, some 40% of voters in the UK are positively keen to elect a socialist prime minister, with a view to getting rid of the horrid thing that is capitalism.

Merryn believes fiction is the best way to win socialists over to the wonders of capitalism, but she struggles to find many good candidates. Starving poets and bestselling authors alike tend to argue money is the root of most evils, along with sex, love, and magical rings fashioned in Mordor.

In the end the best pro-market ideas she can come up with are Great Expectations, Time Will Run Back, Kane and Abel, and Career Girls.

Rather stick to the facts? For those like me whose gift-giving runs to the doggedly didactic, here are my six new non-fiction ideas to give that special someone who won’t take offence:

• Adaptive Markets, by Andrew Lo – A critique of the efficient market hypothesis, I may post Lo’s ambitious book down to The Accumulator with a wry “bah humbug!”

• Investing Demystified, by Lars Kroijer – New 2017 edition! Friend of Monevator and ex-hedge fund trader makes the cast iron case for passive investing.

• This Wisdom of Finance, by Mihir Desai – Really interesting attempt to weave beloved humanities and the much-scorned financial world together. (Give it to Merryn, if you’re seeing her!)

• A Man for All Markets, by Edward Thorpe – A humble genius tells us how he beat the system in Las Vegas and on Wall Street.

• Living Off Your Money, by Michael McClung – This new approach to retirement spending has fired the imagination of many Monevator readers. See The Accumulator’s big review.

• Smarter Investing, by Tim Hale – Okay, so even the latest edition is a couple of years old, but it remains my co-blogger’s recommended read for new investors.

And with that, I’ll wish you all a happy Christmas. 🙂

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What caught my eye this week.

People have a hard time with diversification these days, and it’s easy to see why.

• Developed world government bond yields are still pretty tiny compared to most of the past few decades.
• UK inflation-linked bonds are so dear they even scare my purist co-blogger The Accumulator.
• Cash pays you less than nothing, in real terms.
• Gold, if you like that sort of thing, has been stuck in a bear market for half a decade.

Meanwhile, global shares rally on. Why diversify and give up the gains? Yes, equities look expensive but so does everything else.

TINA, some pundits have dubbed such thinking. There Is No Alternative.

If you can stomach the volatility that will come with the inevitable big stock market crashes, then maybe TINA isn’t the worst date in town. I have been 95-100% in shares at some points over the past decade, so I’m not going to judge you. Shares should outperform other assets over the very long-term, despite the plunges.

There’s no rule that says you have to diversify, just because in theory it will mean a better risk-reward profile for your portfolio. You don’t get style points in investing.

If what you care most about is long-term returns – perhaps because you’re young, or because you’re investing spare money that isn’t underwriting next month’s rent – then going all-in on shares might be reasonable in these tricky times. (Especially if you’ve got a bit of home bias going on. UK shares look cheaper than most, in my view.)

However I would guard against pretending you have diversification that won’t hold up in reality.

Dreamy diversification

I often hear people say that instead of bonds they hold dividend shares, or value shares, or infrastructure funds, or some obscure investment trusts.

The theory, I guess, is these all pay a bit of income so therefore they are a bit like a bond.

Well, perhaps a very little bit.

In reality if markets do plummet 25% in a crash, you’ll probably get your 3% income from a dividend share, say. True. But they’ll still almost certainly take a 20%+ capital loss on the chin, too. Perhaps they’ll even do worse than the wider market, given how popular dividend shares have been since 2009.

Similarly, investment trust discounts can often widen sharply in an equity scare, even if the potentially alternative assets they own do stand up better than the market.

Correlations and consequences

The following graph from Tensile Trading shows three-year correlations for US assets. UK assets will behave much the same.

Note: The stuff that might really hold up in an equity crash is towards the bottom.

Source: StockCharts.com

Yes, it hurts to see the case for lousy old bonds. Honestly, I’m just as miffed as you are.

At this point in a typical cycle we might normally expect to move some of our share winnings into cash and government bonds paying 4-8% or so. To be fearful when others are greedy, as the Sage of Omaha says.

But we can’t get those rates, for all the post-crisis reasons we’ve all read about for the past 10 years.

I understand it’s hard to buy government bonds set to pay you less than 2% a year for the next five years. But if stock markets fall 20%, then that would be a relative return of 18% to the good, even before any potential capital rise.

Am I predicting an imminent crash? No, I don’t think anybody can do that. I do think a correction of some sort is probably drawing near, for what it’s worth. (Very little). But who knows about the timing.

I’m simply saying that if you want to diversify your portfolio, then own assets that actually diversify your portfolio.

Yes, they may be a drag. But if nothing does badly in your portfolio, it’s usually a sure sign that you weren’t really diversified, after all.

• For more on asset allocation in the current environment, watch this recent conversation with David Swensen, famed manager of the Yale endowment fund.

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