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Building a portfolio has 6 distinct steps:
1. your objective (growth/income)
2. your attitude to risk
3. your asset allocation
4. how to select funds, and then applying that process
5. when and how to review funds
6. when to sell between review points e.g. apply a stop-loss
Asset allocation is my concern today. For example, how much you invest in:
· UK vs China;
· stock markets vs bonds or property;
· Value vs Growth;
This is not easy for retail investors. Partly this is because there is a vast array of comment and analysis, most of it appearing compelling, but with no objective means to sort the wheat from the chaff.
The result is often one of these two extremes:
· Punting in and out of individual funds, not very coherent, time-consuming, and stressful.
· Sitting in the same funds, presuming all funds are the same, and not paying attention.
In both cases the result is long term mediocrity, at best, in terms of profits. We know this because independent research tells us this, year after year e.g. the Dalbar Report
Of course, you don’t feel like you are punting – in fact you would possibly be a bit offended by the term. You read the most authoritative journalists. You look in on well-informed chat rooms. You listen to clever family members. But what about their qualifications, their experience giving bespoke advice, and their independently scrutinised track record of long-term success? The likelihood is that all of these are missing – the most basic indicators of whether this person or that forum is worthy of your attention.
Magic Models Or Fraud?
For those who are more methodical, at the other extreme are computerised models for asset allocation, used by the biggest global investment banks, your local adviser, and most stops in between. They assume that financial markets work like a chemistry experiment – if you put ABC ingredients in a test tube at one end you get certain profits coming out the other end.
Magic – except it is little more than seductive maths.
They use complex mathematical models and input a selection of past economic and market data to predict the future. But trying to predict the future of a hugely complex and unpredictable world in this way is “an intellectual fraud”.
Such a chaotic world cannot be predicted in such a rational way because it:
· Doesn’t allow for behavioural issues.
· Doesn’t allow for outliers – extreme events.
Extremes occur commonly in financial markets – with another reminder in 2020 for those who have already forgotten 2007/9 and 2000/3. But they are not allowed for in the bell curve, the Black-Scholes equation, or VaR, the maths at the heart of these models. (more on this in Chapters 4-5 of “Clueless”).
What this maths suggests is improbable actually happens all the time. These models disregard big market moves – but it is the big market moves which bring down the banks, the whole economy…
And your life plans!
For example, the maths model says that:
· When the UK stock market shot up 97% in 1975, this should only happen once in 30,000 years.
· When the U.S. stock market went down 23% in one day in 1987, this was, according to bell curve analysis, something which should only happen “once in several billion years”
(or a 22 standard deviation event – that is odds of 100 quindecillion, which is 100 followed by 48 zeros).
These are “odds so small they have no meaning”, at least mathematically. But they happen regularly in the real world, and do have meaning.
Complex maths models didn’t anticipate the extraordinary crisis of 2008, which brought the world to the brink of Great Depression II. Even Queen Elizabeth felt obliged to ask:
“Why did nobody see it coming?”
…when she visited the London School of Economics (LSE) in November 2008.
To summarise, I have yet to uncover any computerised model on asset allocation which adds value.
Diversification Or Diworsification?
One of the arguments made in favour of these models is that they also give you an asset allocation which is diversified.
Diversification is shorthand for not having all your eggs in one basket.
The theory is that some of your assets will move up while others fall – so your portfolio as a whole does not take a huge hit from being over-concentrated in one area.
As we do not know from where next year’s winner might spring, you should hold a spread of types of funds and asset classes so that, on average, you will get a positive return. In practice, this can get quite complicated, but that’s the theory.
The risks of not diversifying are very clear in the real world. While it might seem strange that anyone would have most or all of their wealth in the shares of one company, it has been more common than you might think, and with ugly consequences.
Even with a fund, despite its inherent diversification across 50-100 different companies, you can get caught out. Domestic Japanese investors would have had their life savings decimated in the years following the 1989 peak. If the WHOLE market is trashed, it doesn’t provide any protection if all the underlying investments are invested into that one market.
Similarly, those who had all their assets in a Woodford fund or in Equitable Life with profits.
A simple stop-loss would have dealt with Woodford and Japan – with Equitable (as with other sales-focussed organisations who still proliferate today) you just need to know when to sidestep the shiny-shoed salesman who wants your life savings. But I digress.
The point is that while diversification is a good idea, you should not be over-reliant on it.
A big problem with diversification is that during the worst periods for markets nearly ALL asset classes, all around the globe, can fall sharply – this was the lesson of 2008, and also March 2020.
This is not an excuse NOT to diversify – it is merely a warning that you really need more than just diversification to limit your risks. Stop-losses add that significant other string to your bow.
I have observed that a large proportion of DIY investors on FundExpert.co.uk (and most successful ones elsewhere) are inclined to be very focussed investors, typically concentrated on either global funds or the UK stock market.
Stanley Druckenmiller said (worth around $4 billion, used to work with George Soros):
“I think diversification and all the stuff they’re teaching at business school today
is probably the most misguided concept everywhere.
And if you look at all the great investors that are as different as Warren Buffett,
Carl Icahn, Ken Langone, they tend to be very, very concentrated.”
First a word of caution – don’t do this at home! At least not quite as aggressively as Mr D.
For most of us, diversification certainly does matter – we are often dealing with our life savings, and we don’t want to make stupid mistakes.
Some will tell you this sort of concentration on one asset class is wrong. But I don’t think it is either right or wrong - this is simply about your preference, and how comfortable you are with this approach.
If you wish to benefit from the dynamism of the best of UK Plc over the long term, this is a perfectly valid approach. You just need to be absolutely clear that you are doing this effectively, and don’t kid yourself otherwise.
“Effectively” means having a clear process to select funds, a review strategy, and a stop-loss, which are steps 4-6 listed at the beginning of this blog.
Even if you invest into just one fund focussed on the UK stock market, it will probably hold the shares of 50-80 different companies - that’s a good spread, a decent level of diversification across many different types of businesses.
You just need to be confident that you are comfortable with the volatility that you will likely encounter with this approach.
In summary, people who tell you there are “accepted models” of asset allocation or “accepted truths” about diversification are holding you back – hugely.
False Sense Of Security
As well as not working (where “working” means achieving a superior investment outcome, more growth) these computer models also give a false sense of risks being limited.
For example, in 2008 everything went down. There was no hiding place – other than cash.
The market will seek out and destroy those who are vain and over-confident or complacent.
Our regulators have warned about such models having this impact. But this isn’t just an issue for retail investors and those who serve them.
Remember those Nobel Prize winners who ran Long Term Capital Management (LTCM) in 1998? Very very bright people, did very very stupid things relying on their extremely complex, but wrong, mathematical model.
Not to lean too heavily on John Major but let’s get back to basics.
Back To Basics
At its simplest, asset allocation is how you choose between equities, bonds, property, and cash.
Once you’ve decided on your attitude to risk this will help you identify the assets/fund sectors which are appropriate for you.
For example, if you agree with the statement:
“I am comfortable with my money being invested in mainstream stock markets, and am aware of their historical ups and downs”…
…it is easy to identify appropriate fund sectors, in what we call “medium risk” fund sectors.
It might include “UK Smaller Companies”, “European Equities” and “Asia excl Japan”.
But not “Emerging Markets”, nor Indian or China funds.
In your investment plan write down the sectors with which you would be comfortable – so as not to be tempted later into higher risk choices.
From this point you can build your portfolio in a variety of ways:
· Single fund solution (“Mixed” fund sectors)
· Fixed split (e.g. endowment model)
· Model “Dynamic” portfolios
1. Single Fund Solutions
The 3 “Mixed” fund sectors have ready-made portfolios, making this a very straightforward approach, particularly for novice investors, but also for more experienced investors who want to keep things very simple and haven’t got a lot of time for alternative approaches.
The three Mixed fund sectors suit different investors:
· Cautious investor?
Try Mixed Investment 0-35% Shares sector
· Relaxed investor?
Try Mixed Investment 20-60% Shares sector
· Ambitious investor?
Try Mixed Investment 40-85% Shares sector
Yes, the names of the sectors are horribly uninspiring, so a little explanation helps.
For example, the most popular is “Mixed Investment 20-60% Shares” i.e. funds contain between 20% and 60% in equities.
With these Mixed sectors, we recommend using our Vintage Fund Ratings
to select the funds with the greatest potential. With these ratings, it is appropriate to review your funds annually (not 6 monthly as with our Dynamic Fund Ratings)
2. Fixed Portfolio Split
You might decide to have a fixed asset split. The “endowment model” used by many pension funds and institutions over decades often boils down to a simple 60/40 equities/bond split.
A UK-based investor who agreed with that statement might have a fixed portfolio of:
30% UK equity funds (1-3 fund sectors)
30% Global equities (just one fund sector? Or up to 7)
20% Sterling bonds (1-5 fund sectors)
20% Global bonds (1-2 sectors)
That’s a lot of potential fund sectors from which to select funds, so you could narrow this down to certain fund sectors, like this:
30% UK All Companies sector
30% Global sector
20% Strategic Bond sector
20% Global Bond sector
You can use the Dynamic Fund Ratings to select 3 funds from each sector every 6 months. This means your portfolio would have a maximum of 12 funds – that is manageable – we recommend 15 funds as a maximum.
3. Bespoke Portfolio
You might make it more bespoke and focussed around your preferences:
40% UK smaller companies (1 fund sectors)
30% Asia excl. Japan (1 fund sector)
30% Global equities (1 fund sector)
Similarly, you could do this by adding in ETFs and/or investment trusts:
40% UK equity, with small cap emphasis
30% Asia investment trust
30% Global ETF
The constraints on your choices are your platform, your knowledge, and trying to keep it simple.
Clear and simple is important.
4. Dynamic Global Portfolio
This is one of our model portfolios, which combine a number of sectors and select funds from those combined sectors.
This one automatically adjusts into asset classes/fund sectors with the greatest momentum, every 6 months – hence “Dynamic”.
This is a straightforward and total solution to the asset allocation conundrum. Here is a quick recap on the Dynamic Global Portfolio:
· We rank funds across all global stock market sectors…
· and select the top three funds, with the proviso that each must be from different sectors.
· For example, imagine the top three funds were all Japanese, the 4th was UK Smaller, and the 5th was European…
· … you would select the top Japanese fund, plus the UK Smaller and European funds, three funds in total.
Since June 2000, a really bad time to start investing:
· Dynamic Global Portfolio has grown an excellent 607%.
· This compares to just 215% for the FTSE World Index
Over 2.8x times greater!
You get a tight focus on funds that have the temperature of their market right now.
It is also important that this method to select funds:
· doesn’t involve hero worship.
· is not based on “hot tips” (broker or weekend press).
· is not influenced by compelling stories created by marketing depts.
(who know the buttons to press!)
These fund selections are based on a method which has been proven to work, with a very high level of consistency, and very large margin of extra growth.
But one further point is worth stressing.
Our method is self-adjusting. It is adaptive.
Your portfolio automatically adjusts as opportunities evolve.
What Next For You?
If you are mostly invested right now, it would be a good idea to try and fit your portfolio into one of the above categories. If the reality is that your funds are all one-offs, and there is no overall plan, do try and re-organise and simplify. It will pay off hugely in the long run.
In contrast, if you are mostly in cash this is not so easy. So, imagine it is 2 years hence, and the catastrophic risks have been left behind. What would your portfolio shape be? Have a go at writing that down now – you can adjust it from time to time for sure – but only have one clear plan at any one time.