This week I read a fascinating article by Phil Oakley about the virtues of a ‘permanent portfolio’. And for investors looking for a simple, low maintenance approach to their savings it makes a lot of sense. Essentially, you just split your fund into four equal parts: cash, equities, gilts and gold. For the non-cash assets, you can use low-cost index tracking exchange traded funds (ETFs). After setting the portfolio up, the only management required is to rebalance the holdings back to 25% each at the end of each year.
The theory is that this asset allocation should cope with pretty much anything. For example, in a higher inflation world the equity and gold holdings should protect your purchasing power. In a deflationary environment, we would expect gilts and cash to help your portfolio through. For a risk averse investor it certainly looks better than just leaving cash on deposit with interest rates as low as they have been.
But today I want to tell you about why I couldn’t stomach this approach for long. I prefer to have over 25% of my holdings in shares. And not just any shares, but fast-growing small-cap shares. It’s by no means a stress-free strategy. It involves a great deal of risk taking. But I don’t think there is any other way I could invest. Here’s why.
UK shares turned that stake into £345,183
Actually, that point about risk tolerance is a crucial one. Take your bank deposit. With a bank deposit you know that there is no risk to your principal (as long as it qualifies for the government guarantee). But at current interest rates, there is very little reward. In other words, it’s not a place to grow your money.
The permanent portfolio approach brings the prospect of a higher return but it does have some risk attached. Historically that risk has been very low. Since 1983 the strategy has a ‘standard deviation’ of 5%. This means that in two years out of every three, the return should be in a range of +5% to -5%. In fact, over this 30 year period there have only been two down years –2.5% in 2003 being the worst.
But what about the rewards? If you had invested £10,000 back in 1983, the permanent portfolio would have turned this into £110,577 with few worries along the way. But UK shares would have turned your initial stake into £345,183.
So I suppose the simple question is: what is the price of a few sleepless nights? Looking at it rationally, I doubt many of us would give up over £200,000 in return for not suffering the anxiety we feel during equity bear markets – despite the obvious extra risk you take on. I think it’s just the price we have to pay for the extra return.
Two important considerations for investors
I think there are two points to be made: one is about time horizon; the other is about temperament and emotions.
Firstly, time scale. Everyone says, me included, that you should only invest in shares if you have a long-term time horizon. If you need to cash in your investments in six months’ time, or even in three years, then a pure equity approach doesn’t make sense. The stock market might be undergoing one of its periodic swoons just at the moment you need to get at your money. When you measure the returns in decades, however, equities do win out. The evidence is there – bear markets happen but they don’t last forever.
Secondly, temperament. This can be a very personal issue. Even though we can be almost certain that sticking with equities over the long haul will be the most profitable approach, some of us just don’t have the stomach to cope with a bear market. And equity investment success demands that we don’t throw in the towel at the bottom. That extra £200,000 requires some willpower to accumulate.
My approach when investing is to seek out small company growth stocks which are at the riskier end of the equity spectrum. In return they also offer the promise of spectacular returns. Unfortunately they hardly ever do this in a straight line. Classic penny shares, those with low share prices and low trading volumes, can jump around significantly from day to day. Often for no particular reason! How then can we help ourselves to be steadfast and stick with our equities?
I think there is a good argument to only look at your share portfolio no more than once a month. By all means read research, ponder ideas, think about the world; but don’t feel compelled to chase every twist and turn in your shares. And if a quarter goes by without you trading, that’s perfectly OK.
The 1987 crash taught me to cope with risk
The 1987 stock market crash provided me with a helpful, if extreme, lesson in this respect. Wall Street fell by a staggering 22% in a single day. UK shares lost over a quarter of their value in a couple of weeks. This was more than enough to panic nervous investors out of their shares. Yet responding to such drama by selling would have been a disaster.
If we had just looked at our equities annually, taking a leaf from the permanent portfolio’s book, we would have seen an 8% return for the 1987 year. Being ignorant of the volatility in October we would have regarded it as a sound year. Over the next two years the market went on to break through its pre-crash levels and make new all-time highs. I suppose experiencing the crash at close hand helped me develop a tolerance for risk; knowing that time can take care of even the most dramatic equity setback.
The permanent portfolio adopts a balanced approach to investment which I’m sure will suit many people well. But it’s not for me. As a proponent of equities for the long term, though, I’m very comfortable with a much bigger allocation to shares than 25%. And as a stock picker I’m keen to have exposure to individual companies rather than indices. This equity approach has served me well over the years; I just need to keep reminding myself of that fact when bear markets test my resolve.
• This article is taken from our free twice-weekly small-cap investment email, The Penny Sleuth. Sign up to The Penny Sleuth here.
Information in The Penny Sleuth is for general information only and is not intended to be relied upon by individual readers in making (or not making) specific investment decisions. The Penny Sleuth is an unregulated product published by Fleet Street Publications Ltd. Fleet Street Publications Ltd is authorised and regulated by the Financial Conduct Authority. FCA No 115234. http://www.fsa.gov.uk/register/home.do
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