In the last few posts on investing misconceptions and index investing, we covered a lot of ground. I admit it is a steep learning curve. Don’t get frustrated if you have to visit and re-visit the information again to get your head wrapped around those concepts. The next step in your investing journey is asset allocation.
As a quick recap, below is a high-level summary in three bullet points:
- You can realize significant savings in taxes during your employment years by maximizing the contributions towards your tax-deferred and tax-sheltered accounts and letting the investments grow tax-free.
- Taxes on investment income are significantly lower than on employment income.
- The best investment strategy is to simply build a portfolio of low-cost, index funds and allow the miracle of compounding to work for you.
Once you understood the benefits you stand you gain and what strategy you need to adopt to realize those gains, the next questions that need to be answered are:
1. Which investment assets should I select within my portfolio of index funds?
2. How should I do asset allocation within my portfolio?
Different Types of Assets
As an investor, there are five major categories of assets (in no particular order) you can invest in:
1. Cash and cash equivalents
2. Bonds
3. Real Estate Investment Trusts (REITs)
4. Commodities (usually through commodity-based funds)
5. Equities
There are other asset classes and sub-divisions within these asset classes as well but for the purpose of this post this is all you need to know.
The two major asset classes that the vast majority of funds invested are equities and bonds. Equities are much more volatile but usually generate the highest returns while bonds are much less volatile but usually generate the lowest returns. A portfolio consisting of mostly equities is considered to be oriented towards “capital growth”. A portfolio consisting of mostly bonds is considered to be oriented towards “capital preservation”.
Modern Portfolio Theory
As an investor, you can construct a portfolio from any one of these assets or a combination of them. You have a lot of choice. But how do you know what is the best choice?
The answer to the question lies in modern portfolio theory (MPT). This theory was the work of Harry Markowitz in his paper “Portfolio Selection,” published in 1952 by the Journal of Finance. He was later awarded a Nobel prize for developing the MPT.
At a basic level, most people understand the concept of risk and return. To have a chance of earning higher returns, one must be prepared to take a higher level of risk. However, MPT brought a paradigm shift in this traditional line of thought by introducing the concept of volatility. Volatility is simply the “spikiness” of an asset.
In his study, the author then performed an analysis of different portfolios consisting of various combinations of equities and bonds ranging from one extreme end to another (100% bonds to 100% equities) and determined their expected return and volatility. The results are shown below.
The curved line connecting one extreme end to another is known as the “efficient frontier”. All that means is as long as you select an equity/bond portfolio along that line, you have achieved the most optimum balance between expected return and expected volatility. Any points below the curve will result in an inefficient portfolio. You will take a lower return for the same level of volatility or worse higher volatility for lower returns. This happens when you include cash, REITs, commodity-based funds or any other asset classes in your portfolio along with equities and bonds.
Points above the curve are impossible.
Asset Allocation – Some Common Myths
So, now you understand that having an equity/bond portfolio is the best option. You also know that a higher equity allocation will lead to higher returns, but with a higher risk. So, how much is the asset allocation that you should have?
The most common line of thought takes into consideration your age and risk tolerance:
1. Age approach: Subtract your age from 100. The result should be your equity allocation and the rest in bonds. So, if you are 30 years old, then hold 30% in bonds and 70% in equities, with re-adjustments every five or ten years according to your age. The reasoning behind this approach is that a younger person is on a longer investing time horizon and can withstand the periods of volatility.
2. Risk tolerance approach: A younger person is inexperienced and has not gone through the gut-wrenching periods of market declines. So, he or she might not be comfortable with sharp drops in portfolio value with come along with high equity allocation.
The most typical investment advisor approach is to simply blend the two together and arrive at a number. So, if you are 30 years old and fairly new to investing, then go with a 60/40 or a 50/50 portfolio. After a few years of investing experience under your belt, you can then move to a higher equity allocation.
I personally do not recommend this approach.
Why?
The simplest reason is because the journey to financial independence is a marathon, not a 100m dash. Once you use these techniques, you will be making regular contributions to your investments during your employment years. In all reality, you can expect to work at your job for least 10 years before you reach the point where your investments can independently generate enough income without you needing to work. That timeline understandably depends on a lot of different factors and will be different for everyone. However, in almost all cases, a minimum of 10 years is necessary.
Case Against Bonds
So, if you are investing for a minimum of 10 years, the two biggest risks that bonds pose are:
1. Inflation – the decrease in purchasing power will erode the value of the bonds. The higher the current and expected future rates of inflation, the lower the bond returns will be.
When it comes to asset allocation, the most common solution provided to protect against inflation is to invest in Treasury Inflation Protected Securities (for Americans) or Real Return Bonds (for Canadians). These are good avenues to guard against inflation when investing in bonds. However, the downside for these inflation-indexed securities is their returns are lower compared to regular bonds.
To get a full understanding of bonds and how they work, you can read the article here.
2. Loss of growth potential – To understand this concept, look at the image below compiled by Robert Shiller and Yahoo Finance. It shows the returns of the stock market for the last 146 years from 1872-2018 for different rolling periods (1 year, 5 years, 10 years and 20 years).
This chart tells a powerful story! Over a period of one year, the amount of red lines (years of loss) are significant. However, once you start looking at longer time periods, the red lines barely become noticeable and volatility takes a nosedive. For any given 10-year period, there were only 13 instances out of 136 where the stock market had a loss. Only 10% of the time. Expand the time frame to 20 years – there are no red lines.
The same chart is presented in an animation here if you are interested.
What Does It Mean?
If you invest for a minimum of 10 years, your biggest risk is NOT on the downside but IS on the upside. With a bond allocation, you are more likely to miss out on the growth potential of equities when stock markets march higher rather than the protection of bonds when markets move lower. In other words, if you invest for 10 years, there is only a 10% chance that you will come out a loser at the end. To me, this is a much better approach rather making a gut call of whether I can stomach a 40%-50% decline along the way or not.
Having a bond allocation in your portfolio makes sense when you are investing with a timeframe of less than 10 years or you have an over-riding personal situation which lowers your overall risk tolerance. Other than that, I recommend that your asset allocation should be 100% equities.
Yours truly,
Rizwan.
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