Where I’ll focus my equity portfolio in 2012

This is the third part in my mini-series on asset allocation. (For the first two parts, see: Five good reasons to hold cash and Why I'm fanatical about corporate bonds.)

You may have been surprised to see me advocating a 50% weighting between cash and bonds. After all, they're not exactly a sexy area of the market.

But I hope I showed you why I think they're so important right now. And bonds really aren't as dull as they may sound. There are some tasty returns out there and you don't need to commit yourself to outsized risks.

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However, those relatively rich weightings come at the expense of equities I'm only advocating 25% here, too. I'll show you why.

Since the early summer, I've been cutting down my positions. I've done that in my personal portfolio and I've encouraged you to do so, too. It's certainly worked out well for me so far.

Given that most portfolios probably hold somewhere between 40% and 60% equities, I'm going to have to fight tooth and nail to show you why I think 25% may be a better bet.

Of course, I'm not totally giving up on equities they've got their merits potential long-term growth, an inflation hedge and many offering very decent income yields too.

It's just that I suspect we'll see some opportunities for bulking up our equity positions down the line at far better prices.

Towards the end of today's issue I'll give you an idea of where my 25% holding is invested. But first, let me show you four reasons I've scaled back on equities in my asset allocation model.

Four reasons for hesitancy over equities

1. The market looks iffy

Investors have a short memory. It was less than three years ago that we were in the midst of a global rout in equities. And yet, the euphoric bull market that came out of quantitative easing and government stimulus quickly silenced the sceptics. For my part, I was happy to run along with the bull.

But it seems to have run out juice at least for the moment. Far from throwing more petrol on our economic fire, governments are now forced to quell the flames.

And a soggy economy isn't good for stocks. Lower earnings lead to lower valuations it's as simple as that. I suspect that part of the reason why the FTSE is trading at a miserly ten times earnings is down to the fact that investors expect earnings to fall. And I can't see anything happening to change that in the short term.

2. Volatility

As a general rule, I don't mind a bit of volatility in stocks. The fact that shares bounce up and down offers opportunities. But there's no doubt that volatility reduces investor appetite. In general investors pay more for stocks with low volatility. I guess it saves fund managers the occasional blushes.

Looking at that the other way round, investors put less value on volatile shares (and markets). And boy we've got some volatility out there now. So it's not surprising to see the market trading on a low multiple.

Here's a chart of the VIX it measures stock market volatility on the US S&P 500 index.

Source: Yahoo! Finance

Steady (and therefore investible) markets usually trade with a VIX rating somewhere between 10 and 20. Yet in recent weeks it has hit 45! Sure we've not hit the highs of 2008 (yet), but this volatility puts a severe dent in what investors are willing to pay for stocks. And that will be the same here in the UK...

While the FTSE looks relatively cheap, it can get a lot cheaper if volatility heads back towards the 40s and 50s. Watch out if a total breakdown in Europe takes us there!

3. Liquidity

It looks increasingly like the global economy is heading into a downturn. And during a downturn cash flowing around the system stalls it's already hit the European banking system. Bills are left unpaid, investment is put off. And consumers save as much as they can as fear turns to panic. A family can quite easily cut back on luxuries. But a business can't...

Very few businesses have any luxuries to cut back on. Most have already been cut-back and pruned to the nth degree. And overheads like staff and rent commitments take time and money to reduce.

Cash-strapped businesses usually cover a shortfall by asking a friendly bank for a few quid. But the banks are de-leveraging. So firms go to specialist lenders that take assets as collateral. That puts shareholders' assets at risk.

And woe betide any company that asks shareholders to stump up a few quid when the markets are choppy. The share price gets trashed. We saw it in 2008. Banks, house-builders and retailers looked to shareholders for a rights issue and suffered devastating mark-downs.

A liquidity trap stuffs us shareholders. Either we lose dividends, or have to stump up cash (probably both!) At worst, we can lose the lot through bankruptcy.

4. Long-term returns

It's often argued that equities offer the best returns over the long run. But that's not necessarily so. Recently I used some data quoted by Tim Price of The Price Report that suggests otherwise.

Sure, the 80s and 90s were great decades for stocks. But they should be seen as the outlier. It's certainly not the norm.

Equities seems to be the default setting for most financial advisers. Be it in the newspapers, IFAs and in particular City analysts.

Yes, there are great stocks out there. But no you shouldn't punt the lot on equities as a whole.

I'm going for a lowly 25% right now.

Where to invest your equity allocation

During 2011 we looked at many interesting equity ideas. I mentioned several investment trusts (ITs) and quite a few ETFs, as well as some interesting stocks.

ITs and ETFs are a great way to get exposure to various sectors of the market and they won't cost you a fortune in management fees either. We've used them for exposure to emerging markets, pharmaceuticals and high-yield stocks to mention but a few.

For most investors, I'd advise using these broad funds to get about half your equity exposure. That leaves the remaining half for individual stocks.

If you're not keen on picking your own stocks, then I'd advise using even more ITs for your allocation.

And as I explained, I'm looking forward to introducing some unit trusts to our select club of investments in 2012. There's good reason to believe that fund management costs will start to come down to some sort of semblance of fair value.

In terms of geographic breakdown, I'm still keen on the emerging markets. Their economies are typically in better shape than developed western ones.

I'm looking at 40% UK, 20% emerging markets, 20% Asia (incl. Japan), 10% Europe and 10% US.

These are just rough allocations and they tend to change over time. But I suspect most investors are much more heavily exposed to the UK. If that includes you, then don't worry. The FTSE 100 has a fair degree of international diversification inbuilt.

Most of my foreign holdings are through investment trusts, leaving the rump of my UK allocation for individual stocks.

Although I hold commodity related stocks too, I've not included them in my equity allocation. That's for my commodities allocation.

This article is taken from the free investment email The Right side. Sign up to The Right Side here.

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