I am not a professional trader. I’m a private investor, like most of my readers.

Why then am I buying in a bear market?

After all, as private investors our investing directly affects our quality of life.

We can spend spare money on shares, or instead we can go on holiday or buy a new TV.

There’s no money made just by playing the game for us, unlike for a salaried fund manager.

Yet despite not being paid to do so, this morning I purchased shares in a FTSE 100 ETF when the market was at 5360.

As I type this post, it looks a brilliant move – the market has moved 300 points higher. But by tonight it could seem folly if the market crashes lower.

How are you supposed to invest at times like these?

My approach at all times is to be ‘fearfully greedy’.

It may sound like something you’d hear an English child exclaim in Mary Poppins, but being fearfully greedy has its roots in Warren Buffett’s strategy. And I believe it’s the only way I’ll prosper through investing.

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It’s a truth universally acknowledged that diversifying your portfolio among different asset classes is a No Brainer.

Sure, just as with brushing your teeth or the merits of jogging, you’ll find a few backwoods men howling at the wisdom of asset allocation. But the general consensus is you can likely reduce the volatility and thus the uncertainty of the returns from your portfolio by spreading your bets between different kinds of investments, without reducing returns too badly.

In the old days, such financial black magic would have been done by a pension fund manager or a kindly broker, who would have charged you heavily for the privilege. These days though many investors are managing at least a portion of their funds for themselves. For too many of us, that means big equity portfolios and not a lot else.

I’ve been looking to address this problem in my own investing pot. While I’ve currently got a fair amount of cash (about 25 per cent of the total fund value, earning around 5% a year), elsewhere I’ve ridden the bull market in shares since 2004 at the expense of wider asset allocation. With markets looking shakier, I don’t want to push my luck.

Buying ETFs gives you quick, broadly spread exposure

From my research, I believe Exchange Traded Funds (ETFs) offer the potential for a rough-and-ready overhaul of my asset allocation strategy. Below I’ll go through the ones I’m looking at and in some cases have already invested in. You can decide for yourself if they have a place in your own portfolio.

Today’s ETFs offer you instant diversification benefits from assets as diverse as:

• Government
• Corporate bonds
• Commodities like gold, cotton and timber
• Foreign stock markets
• Commercial property.

ETFs are cheap – you can buy them through an online share broker in the usual way you’d buy any share, with no initial charge beyond the dealing fee. They simply track indexes so the annual charges are low, too. With an ETF you’ll never outperform any asset market, but you won’t underperform it by more than the annual charge either.

Now, I’m not claiming that ETFs are a perfect solution for all asset allocation issues. For instance, UK investors sometimes buy various Gilts (the age-old name for UK government bonds) to create timed income streams to meet future liabilities.

Buying a Gilt fund won’t do that – instead you’re simply tracking an index of various gilts, as determined by the ETF provider. It’s a one-time buy-and-forget strategy. But for my part, that’s all I currently need Gilt exposure to do. Same deal with timber and oil. I don’t want to become an expert on the cotton crop or the diseases afflicting cocoa beans, and I don’t want to be trading into some in spring and out of others come December. I just want my portfolio to have exposure to the results of those who do, primarily to diversify my equity portfolio.

ETFs are perfect for such quick diversification in my opinion, especially given their low charges, so let’s consider a few to get started. (I look at using exchange-traded funds to get direct exposure to commodities in a different post about these so-called ETCs.)

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2008 could well be the year when we investors are reminded about the benefits of asset allocation. This rather academic sounding discipline is generally forgotten in times of roaring stock markets, but when the weather gets rougher, people are glad they’ve packed umbrellas as well as beach towels.

I plan to learn a lot more about asset allocation ahead of 2008, but the principle is simple enough – don’t have all your eggs in one basket. Most private investors know about diversification, buying a range of shares or an index tracking fund to spread their risk of a particular company putting in a stinking performance or even going bust. But eggs is eggs, and a basket of shares is only a basket of shares.

You need different asset classes as well as different assets

Asset allocation says you need to have several baskets, investing in the likes of cash, government bonds (Gilts in the UK, Treasury bills in the US), corporate bonds, property, precious metals, commodities, emerging markets and so on, alongside your shares. The downside is likely reduced returns, especially in the long-term.

The upside is reduced volatility, as a bad performance by one asset class is hopefully compensated for by better returns from another, uncorrelated, asset. Some commentators go further to claim average performance will be boosted with optimal asset allocation, although luck and timing would seem to play a part here. Shares are the best performing asset by far over the past 150 years, after all.

So how much should you put into what asset class? That’s the $6 million question, and there’s no firm answer you can trust, since even the most detailed studies are based on past returns. Nobody knows what will happen in the future. [continue reading…]