Take it from Ray Dalio - One of the world’s most successful hedge fund managers who has over $160 billion on his books.
To become a better investor, you need to manage risk. By understanding asset allocation, you are taking a fundamental step towards this.
Different assets are like having various tools in your toolbox. They all serve a unique purpose and can be used in different combinations and at different times to produce strong market returns.
Here is a breakdown of how we can look at this topic.
It’s something that a company or a person owns. It comes in various forms, both tangible eg goods, property, cash, shares, or intangible like intellectual property.
Good asset allocation will result in predictable, secure wealth generation over time, even in unfavourable market conditions.
What are the common investing asset?
Each asset class has advantages and disadvantages. At different times in the market assets will underperform and over-perform. Certain assets will historically return more (equities/venture /crypto) but will also be volatile year on year.
The pros - It’s a low-risk asset as its value doesn’t change radically day to day aside from currency fluctuations. It’s useful for three reasons. Firstly to act as a security and buffer, so you don’ have to sell any other investment at an unfavourable time. Secondly, to gather interest in a saving account, particularly in high-interest environments. Lastly, to hold as capital waiting to be deployed in another asset class at a favourable time.
The cons - Only when it’s a high-interest environment does it hold the potential to make a reasonable return. It also has one worst hidden enemy - Inflation (a continuous rise in the general level fo prices). Inflation will decrease the value of your cash every year. E.g. If you brought the same goods and services for £1000 in 2019 vs the year 2000 you would need an additional £695.89 to buy the same product! (With inflation averaging 2.8% / year)
The pros - Bonds are reliable sources of income with a fixed interest. They will return more than cash but not as high as equities historically. They help smooth the equity ride when it’s very volatile.
The cons - Bond risk varies with different types of bond classes. You can buy secure bonds backed by the government or high yield more risky bonds. In rare cases, bonds can default meaning you lose all your capital. The duration of bonds periods varies, meaning you might have to hold a bond for a long time to see a return.
The pros - Equity should be at the heartland of most investment portfolio’s. Historically this is the best asset class for returns the last 120 years. You are buying a part of a living breathing company! You can also be paid dividends which are companies profits paid back to investors. Eg if you own £100 in shares at Apple and they give you £3 you would have a dividend yield of 3%.
The cons - Although it has the best returns over a long period, equity can be volatile, and dividends are not always guaranteed. Be prepared to ride the storms.
The pros - Real estate and property have shown over the years to make good returns sitting between bonds and equity.
The cons - Depending on how you invest, it can require lots of maintenance if not doing through a digital asset and can be geographically non-diversified. Similar to equities, it can be volatile but generally more stable.
The pros - Commodities often perform in an uncorrelated way to the market and other assets, making them very useful as a way to weather the bumpy ride. The stability of the commodity is down to the asset type, e.g. gold vs oil.
The cons - You need specialist knowledge to be able to trade specific commodities successfully, and they can be very volatile in unpredictable ways through the weather, epidemics and human-made and natural disasters.
The pros - Private equity has proven to produce exceptional returns for professional investors. If you pick a ‘winner’ you can make a fortune, and with some creative accounting, you can also reduce your tax bills (at least in the UK through EIS & SEIS).
The most substantial return recorded happened in 2014 when Facebook acquired WhatsApp in 2014 for $22B, turning Sequoia Capital’s $60M investment into a cool $3B! Side note: The founder (Brian Acton) was rejected for a job with Facebook in 2009…. God that’s sweet.
The cons - Private equity is hard to get access to, and returns are highly volatile. It’s a winner takes all game. To stand a chance of making a decent return you need access to exceptional deal flow, the same share rights as professional VC’s and be willing to hold an illiquid asset for a long period of time. You can’t sell your shares easily like the public stock market. (Some recent developments in the market have changed this, but that’s for another post)
The pros - The new kid on the block. Cryptocurrency has flooded headlines for the last couple of years. It’s a new asset class and has produced exceptional returns in the short term it has been on the market.
The cons - It’s highly volatile, not legally (yet) or illegally enforced and has been a hot area for fraud. You want to make sure that any investments you are making are through a secure, trusted source.
Ok, so we know about assets, and they’re pros and cons. So what do we do? We should go with the best performing asset overtime - right?
If we look at historical data for the two most popular asset types - Equities and bonds you can see below that over the last 120 years global equities (after inflation) have outperformed bonds returning 5.2% vs 2.0%
But hold on. What about other assets? Cryptocurrency - Specifically bitcoin has only been around since 2014 and has returned over 11,178% So we should go all in?
Well, not quite. It's all about understanding your relative investment needs and risk tolerance. The issue is that performance is relative to time, and as humans, we need to get on and live our lives. That involves spending capital, meaning selling and buying assets which destroy returns.
While investing, you want to avoid having to sell your investments at a poor market timing. Smart asset allocation allows you to manage this.
Ask yourself these questions:
J H Collins discusses two stages:
The Wealth Acquisition Stage - You're at the earlier stage primarily focussed on building wealth. At this stage, you should over-index on medium and sometimes higher-risk assets.
Wealth Preservation Stage - You're at the later stage primarily focussed on preserving your wealth. At this stage, you should move your assets towards medium and lower risk assets.
If you need a high level of liquidity, you want to avoid holding a high percentage of high-risk assets that often have low liquidity—namely, private equity and cryptocurrency.
This one isn't essential, but if you are going to take a more active approach (choosing your investments) rather than a passive route (investing in an index), it helps to invest in areas that you understand. Equally, if you want to invest in physical real estate, ask yourself if you want that time burden of active management.
Depending on your answers, you will fit into different portfolio types. By no means are these fixed. I wanted to give you a few profiles to bring this idea to life. You need to tweak this for your circumstances.
One note on risk. A lot of investment advice is that you should never touch higher risk assets if you're an average investor, but this isn't true. You can and arguably should. However, you must ensure you have the correct asset set up so that if your high-risk investments go south, you don't have to sell your other assets.
That's why having a cash barrier is always useful.
Ok, so we know about assets, we understand them, and we have a good idea of what assets we should allocate, but how do we quickly achieve this diversification?
You could achieve this in many different ways through investing in individual companies, but this requires a lot of time and effort to work out where you should place your capital.
I do advocate active investing in individual companies and through investment trusts under certain circumstances. However, the simplest and quickest way to do this is through vanguard funds and ETF’s.
I recommend them as they are low cost, have a good variety of funds to suit your needs and have excellent customer service. You can always layer your investments after you have got a solid base.
I’ll share two versions of the same investments as some differences are depending on where you live. The US has a better fee structure but sadly you can’t open a US account if you are a UK citizen and pay tax in the UK.
You want to invest in global funds or ETF's to diversify your geographic risks further.
The fund holds 3486 companies with over $822.4 bn under management at an incredibly low cost of 0.04%. Over the last 10 years the fund has returned ~ 12% annually and ~ 6.7% annually since its inception in 2000. $10,000 invested in 2010 is worth over $33,381 (As of May 2020).
If you have under the minimum $3000, I recommend the ETF version, which allows you to buy at the price of a single share currently ~ $153 (May 2020).
This fund holds 3,424 companies with $4.2bn under management at a low cost of 0.22% It was only established in 2012 so doesn’t have as much historical data, but over the last 8 years it has returned ~ 8% annually. £10,000 invested in 2010 is worth over £19,267 (As of April 2020).
This fund holds 9398 bonds with over $264.3 billion under management also at a low cost of 0.05%. Over the last 10 years the fund has returned 3.87% annually, and since inception in 2001, 4.42%. $10,000 invested in 2020 would be worth $14,616.
This ETF holds 4837 bonds with £37.7 Million under management with a low cost of 0.10%. It’s a relatively new fund launched in 2019 so performance data is not available, but you can expect this to mirror the US version of around 3 - 4% annual return.
This fund invests in real estate trusts owning over 183 different companies. These companies purchase office buildings, hotels and other types of property. It launched in 2001 retuning on average ~ 9% annually with a low fee of 0.12%.
If you have under the minimum $3000, I recommend the ETF version which allows you to buy at the price of a single share currently $79.22
UK: I can’t find a suitable fund or ETF that offers the same level of diversification as the US counterparts; for this reason, I would not pursue it. If this changes I’ll update it! (If you hold UK shares you are likely to be indirectly holding property focussed shares anyway.
This fund invests in commodities holding energy, grains industrial metals, livestock, precious metals and softs. It's a relatively new fund only being established in 2019. Since then its lost -14.84%! However, this doesn't mean that you should not consider investing. Performance will vary over time.
UK: I can't find a suitable diversified commodities ETF that I like but will update if I find one.
Warning: I would strongly advise you not to invest in this class if you need capital to be liquid. These are very high risk investments.
UK + US: Coinbase
There are lots of horror stories with people loosing thousands through cryptocurrency from being hacked or loosing their physical wallets. There are lots of services you can use but one of the safest in the game is Coinbase, they are certainly not the cheapest but for this asset class you want security above all else.
Warning: I would strongly advise you not to invest in this class if you need capital to be liquid. These are very high risk investments.
There are lots of way you can invest in private equity from angel investing, crowdfunding and investing in VCT's. I'll provide a few links with resources.
However, if you want to make these types of investments, I would strongly recommend not trying to invest in individual companies. If you don't have professional investment experience, you will lose. The game is not in your favour.
Instead, I would recommend investing in a hybrid investment trust that invests in public and private companies with a maximum exposure of 25% of the total holdings. These private companies are selected by professional investors who have access to some of the best deal flow in the world. If you want to get exposure to the likes of Airbnb, Stripe and Transferwise, you can invest through Scottish Mortgage Investment Trust.
It's the opposite of an index fund, investing in a highly concentrated collection of companies with the top ten investments accounting for 54% of the whole fund! For an active investment trust, this comes with a highly competitive fee of 0.36%.
As part of a diversified portfolio, I would recommend this to everyday investors.
Ok, we are at the final sprint. You have a diversified portfolio! What now? Well, the simple answer is do nothing. That's the point.
You need time for your portfolio to get to work and do its magic.
Avoid trying to sell and buy new assets. Remember, we are investing, not trading.
But this doesn't mean you shouldn't be keeping an eye on it over time to manage it properly. There are a couple of scenarios that you need to consider.
a) Gradual rebalancing
Over more extended periods, you will find that your initial asset allocation percentages that you purchased will change. Maybe equities become far more dominant and your bonds exposure shrinks in comparison. You want to keep an eye on this. Annually consider selling some of your asset classes to get back to your original portfolio distribution to manage risk.
b) Steady withdrawal
You might be thinking but hold on I want to live and spend my money! Well, the quick rule is that you need 25 times your annual spending before you could have no other income and live off your investments withdrawing 4% each year of the value.
So image your average annual spend was £40,000, then you would need £1m in your total portfolio to ensure you never ran out of money in your life. Until then, you want to do your best not to withdraw as much money as possible. I know... Easier said then done.
c) A significant market move up or down (20% up or 20% down)
There will be market fluctuations over a short period when one of your assets will skyrocket, and another might fall rapidly.
At these points, you want to consider selling part of your position's gain (15% - 40%) of your strong performing asset and buy the underperforming asset. Generally but not always, when one asset class rises, another asset class will fall in demand. By doing this over time, you will buy more of the cheaper asset and will benefit in the long run.
If you have invested in high-risk investments assets like cryptocurrency or venture capital, you should consider rebalancing more often. Take some money and reinvest it, it helps manage risk and ensures you are better diversified. By only selling part of your position, you maintain your upside and also protect your downside.
It also has the added benefit that you can now sleep at night without worrying about a single investment.
Who doesn't want that?