Many studies suggest that asset allocation is a far more critical driver of long-term investment returns than the underlying holdings in your portfolio.
In other words, you can afford to make quite a few mistakes in selecting, say, individual stocks, as long as your overall portfolio is not too heavily exposed to equities.
There are four asset types that I use within client portfolios at my asset management business.
Bonds represent ‘ground zero’ in the current financial landscape. With several countries effectively bankrupt, you should choose your bond investments – if any – with extreme care.
The interest rate cycle is slowly starting to turn back upwards. This is hazardous for bonds, whose prices invariably fall when interest rates rise, because conventional bonds have fixed coupons. The value of these fixed payments becomes less attractive when interest rates are rising. A 5% coupon looks nice when interest rates are at 0.5%, but it’s not so hot when they’re at 7%.
Eurozone interest rates have already started to tick up, with the European Central Bank finally remembering that it has an obligation to try and control inflation. For investors in the US and the UK, no such luck. The economies and financial systems of the ‘Anglo-Saxon’ economies are so fragile, it will be surprising if monetary policy rates rise at all this year, even though they should, given the devastating impact of inflation upon savers.
Obviously, these come with a degree of price risk. But there are really two types of risk that will affect our portfolios, and only one is a long term threat.
Day-to-day price volatility is a function of any investment once you venture outside the realm of cash deposits. That is a simple fact of life. The market ebbs and flows. If you are a regular saver, market volatility can work in your favour. If the market trends down, and you have decided to allocate a fixed amount of capital to investments on a regular basis, lower market prices will give you greater buying power during downturns. Such ‘pound cost averaging’ is almost certainly a better route than trying to time the market.
The sort of risk you should be most concerned by is the risk of a catastrophic loss of value – the loss of permanent capital. For this reason, I have a natural tendency to favour more defensive / high quality equities, where I consider that this risk of catastrophe is massively reduced.
One of the best metrics I have found for identifying relatively ‘safe’ equity investments is the Altman Z Score. While the investment environment remains fraught, I’m convinced that a selection of well-chosen and high-quality equities stands an excellent chance of preserving real wealth over the medium term, and acting in part as an inflation hedge.
Absolute return funds
These are not an asset class per se, but more of an objective. I use them because I like to be diversified against market shocks. A good absolute return fund manager has an explicit mandate to generate a positive return irrespective of market direction – and in many cases has the track record to prove it.
In some instances, absolute return funds can be hedge funds, which are widely shunned by individual investors and their advisers on the grounds of cost. But what really matters to any investor is the net, after-fee return. I’m happy to pay what might look like very expensive fees to third party managers, provided that my net return is still a decent one. Fees are a complex part of the asset management business. Buying cheap does not guarantee happy outcomes. Sometimes, it pays to pay up for quality management.
These are effectively non-financial, tangible assets. Gold and silver still represent the lion’s share of the real assets component of my portfolio. And they will do for as long as our monetary authorities continue to believe that printing money will sort out the world’s problems. It will not. For as long as the world’s paper currencies (and notably the dollar) continue to be degraded by central banks and state Treasuries, and for as long as most governments continue to run colossal deficits and national debts, it will make sense for investors to retain exposure to ‘stateless’ monetary assets such as gold and silver whose prices cannot be manipulated to order by government.
But it doesn’t end with gold. Agribusiness investments also make sense, and I am actively looking for appropriate vehicles in timber, forestry and commercial property as and when the right opportunities, in the right structures, arise.
A few final thoughts. From an analytical perspective, there are always two ways of assessing the markets: ‘top down’ and ‘bottom up’.
Top-down investing is also known as ‘the fundamentals’. It makes sense to give some consideration to the macro picture, but this is always subjective, and therefore prone to error. More to the point, there have to be limitations to any process of predicting things which will never be fully predictable. Or in the words of Voltaire: “Doubt is not a pleasant condition, but certainty is absurd.” If we have ever lived during conditions of uncertainty, we are doing so now.
Bottom-up investing, by contrast, considers the individual fundamentals of specific investments, companies and their stocks, for example. Bottom-up analysis normally works, but when it goes wrong, it can go horribly wrong.
Bottom-up investors in equities, for example, had to contend with a vicious bear market in 2008 which saw value stocks and growth stocks alike get destroyed by forced selling – flying in the face, in other words, of the fundamentals.
So you stand the best chance of a successful investment outcome by conducting both forms of analysis. Some form of roadmap for the future helps, provided the underlying analysis is broadly sound. And bottom-up consideration helps to sort the wheat from the chaff.
I’m convinced that, within this context, taking this well-diversified, four asset-type approach gives any investor sufficient flexibility for whatever their time horizons, income requirements and individual risk appetites might be.
• This article was first published in Tim Price’s fortnightly newsletter, The Price Report.
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