Asset Allocation for All Seasons


Welcome back – I hope you had a great summer! It’s hard to believe it’s already almost September. The last four months of the year can be a busy time for investors. Many people have committed to targets earlier in the year, maybe in their New Year’s resolutions, for how much money they will put away or invest during the year, and suddenly the last quarter is looming. We all know that December is pretty much a write-off as you get busy preparing for Christmas and end of year holidays, so there are only really three months left to take action.

It’s been a pretty eventful year, not to mention a volatile summer. At one point in August the VIX Index, otherwise known as the fear index, surged by 62% in three days. (Bloomberg) A person with money to invest right now is looking at a constant stream of rather off-putting news: North Korea, terrorist attacks, protests in the US, Brexit, oil prices slumping again, not to mention central banks mulling major monetary policy decisions. So how on earth do you choose investments at a time like this?

Once again we need to go back to basics and build a core portfolio that can withstand the risks a fast changing world can throw at it. A lot of people already get the concept of spreading their risk around, not having all their eggs in one basket, but are perhaps unsure of exactly how to achieve this. Today we will look at some advice from an expert.

Ray Dalio is the founder of Bridgewater Associates, the world’s largest hedge fund with some $150 billion in assets under management. Coincidentally, while I was drafting this post, I found this article in the Financial Times quoting the man himself on a rise in risk in the current climate. Needless to say, his opinion is highly sought after.

Tony Robbins interviewed Dalio for his book MONEY Master the Game: 7 Simple Steps to Financial Freedom and asked him how regular investors should organise their portfolios. His advice is both simple, and easily implemented:

According to Dalio there are four things that move the price of assets:

  1. Inflation
  2. Deflation
  3. Higher than expected economic growth
  4. Lower than expected economic growth

Also, there are only four economic environments, or seasons, that will affect asset prices:

  1. Higher than expected inflation (rising prices)
  2. Lower than expected inflation (deflation)
  3. Higher than expected economic growth
  4. Lower than expected economic growth

Unlike the four seasons we associate with nature, these seasons do not necessarily come in order, and it is difficult to predict how long a season will last. Each asset class will fair differently depending on the prevailing season. Therefore Dalio says we should have 25% of our risk in each of the categories. His strategy is known as All Weather, and ensures the portfolio is covered, regardless of what season comes next.

Dalio breaks down which assets will perform well in each of these seasons:

  1. Higher than expected inflation – commodities / gold, inflation linked bonds
  2. Lower than expected inflation – government bonds, stocks
  3. Higher than expected economic growth – stocks, corporate bonds, commodities / gold
  4. Lower than expected economic growth – government bonds, inflation linked bonds

Tony Robbins persuaded Dalio to simplify this into an asset allocation that individual investors can follow. It’s called the All Seasons strategy and it looks like this:

  • 30% stocks
  • 15% intermediate term bonds (7-10 year)
  • 40% long term bonds (20-25 year)
  • 7.5% gold
  • 7.5% commodities

This portfolio could easily be constructed with a low cost portfolio of ETFs, as suggested in this article. (a year old but see the ETFs listed in the middle of the article)

Many people are surprised by the high allocation to bonds, but Dalio points out that stocks are three times more volatile than bonds, therefore the damage they can do in the wrong environment needs to be controlled. Most investors have their asset allocation set up to do well in a good market, but very badly in a bad market.

He also points out the importance of rebalancing annually so you do not get out of balance when one segment does particularly well. I would also stress, for the international investor, the importance of establishing your base currency to control currency risk over time.

So, if you are looking to add to your investments over the coming months, make sure you are considering your asset allocation carefully and set yourself up to thrive in all four seasons.

Disclaimer: This should go without saying, but the information contained in this blog is not investment advice, or an incentive to invest, and should not be considered as such. This is for information only.

Core vs Satellite


So, you have completed your financial profile, worked out your base currency and risk profile, and committed to a strategic asset allocation that fits. You should be feeling pretty good about your investments. However, isn’t this all a little bit…boring? You just read that gold mining stocks are about to go on a tear, or your friend showed you a cool biotech fund you want to get into, or how about cryptocurrency? There are always going to be some more exciting investments out there with potentially big returns, but where do they fit into your strategic asset allocation? The answer is, they don’t!

Firstly, you should be very careful investing in “the next big thing”. Often, by the time you hear about a cool new opportunity from your friend at the bar, the smart money has already been invested for some time and is looking for suckers coming in late to sell to. Having said that, at any given time there may be really exciting long term investment opportunities for people willing to tolerate some extra risk. They are just a little “niche”.

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This is where you need to understand the concept of a core/satellite approach. Simply put, the core of your assets, that is 80-90% of your investments, should be in your strategic asset allocation. This is serious money that you are planning to spend later on important things like your kid’s education and your retirement. If you really want to invest in platinum, or alternative energy, or bitcoin then this should be considered a “satellite” holding. It’s perfectly ok to allocate 5% of your investments to something more speculative, just don’t go all in! Over time we will look at some potential satellite holdings that you may want to consider.


Strategic Asset Allocations

So what might an actual strategic asset allocation look like? This depends entirely on who you ask at any given time, but it’s good to have a general idea. Below are three examples for risk profiles Conservative, Balanced and Growth:

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Note how a conservative investor has a heavier weighting to cash and bonds, whereas a growth investor has a heavier weighting to equities. These are by no means set in stone and may vary from year to year, but they are not going to vary from month to month – if you are changing the allocation that often then you are behaving tactically. Professional investors do this as a matter of course: Their strategic weighting to domestic bonds may be 15%, but if they are currently negative on bonds for a particular reason, they may adjust this tactically back to 10% for a period. However, when they rebalance at the end of the year they will rebalance back to the original strategic weighting of 15%.

Here’s what a strategic asset allocation may look like with a “tactical overlay” (T) – a temporary adjustment for tactical reasons:

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Please note that these are not investment recommendations, they are simply examples to show you what certain asset allocations may look like. If this level of detail is a little overwhelming, don’t worry. We will look at ways to simplify this in future posts.

Buy Low, Sell High!


I’m sure you have heard the mantra “buy low, sell high”. That’s because it is the number one objective of investing. But how do you actually go about this in a fast changing world without constantly having to watch the markets? The answer is more straightforward than you might think:

Let’s keep this really simple – say you have a portfolio that is 60% in stocks and 40% in bonds. (of course your portfolio will be much better diversified than this but we’re going for simple here!) Over the course of a year the stock market soars and the bonds stay about the same. You’ve had a really good year in your stocks. In fact, they’ve done so well that the balance of your portfolio has changed to 70% stocks and 30% bonds. Now, you haven’t changed anything yourself. It’s just that one of your asset classes has increased in value and therefore in weight.

Then the next year, guess what? The stock market continues to do well! Your bonds stay about the same and the stocks have such a great year that the value of your investment goes up significantly. And you go out and celebrate! Your asset allocation is working perfectly!

What you haven’t noticed is that now your portfolio is 80% stocks and only 20% bonds. And what happens the next year? Yes, you guessed it – the stock market crashes, you are over-exposed to it, and all those gains are wiped out…you failed in your attempt to buy low and sell high.

So how can this be averted? Simply, by rebalancing. At the end of the first year you automatically sell some of your stocks (selling high what you bought low) and buy bonds, restoring your asset allocation to 60/40. At the end of year two you do the same.

Then year three comes and the stock market goes down, but the 40% you have in bonds is there to protect you. In fact, it’s quite likely that bonds do well that year. So in that case, at the end of the year, you will sell the some of the bonds (high) and invest back into stocks (low). That’s it!

So, once you have understood your risk profile, and diversified into a blend of assets weighted to match that profile, the last thing to do is make sure you rebalance on a regular basis so the weightings don’t get out of whack.

Rebalancing annually is how you automatically buy low and sell high, without stressing yourself about the direction of the market.


Asset Allocation – an introduction


It’s quite likely that you have heard the term Asset Allocation. It may mean different things to different people, so I will try to give you an overview of where the term comes from and what I mean when I refer to it.

First some history: The pioneer of asset allocation was Harry Markowitz. As early as 1952 he was writing on diversification, efficient frontiers, and modern portfolio theory. Understanding Markowitz is about recognising that most investor’s requirements revolve around obtaining reasonable investment returns without excessive volatility (risk). In other words, it’s not about high returns, it’s about blending different asset classes to produce average to good results at lower risk.

Since Markowitz, further studies have concluded that asset allocation constitutes the most important step in portfolio construction, accounting for more than 90% of the variability in portfolio performance over time. (G.P. Brinson, B.D.Singer, G.L. Bebower, “Determinants of Portfolio Performance II: An Update”, Financial Analyst Journal, May-June 1991)

Another interesting person to read up on is the psychologist Daniel Kahneman, who won the 2002 Nobel Memorial Prize in Economic Sciences for his work on the psychology of judgement and decision making. Most importantly, Kahneman points out that individuals are more depressed with investment losses than they are satisfied with equivalent returns. In other words, people hate losing money more than they like making money. Which brings us back to Markowitz’s theory that, although people might think they want high returns, what they really want is reasonable returns with the minimum amount of risk possible.

If we were to put Markowitz’s work into a diagram, it would look something like this:

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We can refer to the return on cash as the “risk free rate”. This will, of course, vary depending on your base currency. If you take all of your money out of the bank and put it into private equity, there is a chance of very high returns, but the risk will quite literally go off the chart. However, if you diversify through cash, bonds, base currency stocks, overseas / emerging stocks, property and alternatives, you will find that the risk increases, but not by a huge amount. This means it is possible to put a little of your money into more racy investments without massively increasing your overall risk.

The actual weighting you should allocate to each asset class will depend on your attitude to risk, which we will consider in a later post. It will also differ for regular monthly investments vs lump sum investments. For now it’s enough to know that this “strategic asset allocation” is used to form the core of an investment portfolio, allowing you the peace of mind to get on with more important things!

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