A billion dollar question on which numerous researchers, advisors, and investors have spent, or rather wasted, thousands of hours contemplating. It is not an exaggeration to say that there are countless papers, articles, and books on this topic that only confuse everyone even more.
Optimal portfolio allocation or the best portfolio balance aims at minimizing risk while maximizing returns. The best allocation strategy depends on your needs. Experience, age, risk appetite, available capital, and time horizon are also critical factors. Before going into the details it is imperative to understand the concept of diversification.
So what exactly is portfolio diversification?
Simply put, diversification is the process through which one can balance out price movements among different securities. For instance, if you were to invest 100% of your funds in the shares of Apple your entire portfolio could go bust if Apple were to go bankrupt. However, if you were to own shares in Apple and Coca-Cola, negative price movements in one stock could be absorbed by positive price movements in the other.
So how exactly do I diversify my portfolio?
Diversification can be achieved by investing in different types of stocks or asset classes such as bonds and money market securities. Money market securities being a fancy name given to securities with high level of liquidity or easy to sell items. Note that money market securities have short-maturities, lasting less than one year.
These asset classes have sub-classes that have varying levels of associated risk and returns. The table below provides a snapshot.
|Asset Class||Important Points||Risk||Return|
|Fixed Income Securities||Includes corporate and government bonds||Low(Govt Bonds) and High to Low(Corporate Bonds)||Low(Govt Bonds) and High to Low(Corporate Bonds)|
|Emerging Markets||Securities from developing countries||Usually high||Usually high|
|International Securities||Securities in foreign countries - added country risk||Depends on the country and security||Depends on the country and security|
|Small- Cap Stocks||Low liquidity, firms are trying to establish themselves||High||High|
|Mid - Cap Stock||Market cap between $2 BN and $10 BN||Medium||Medium|
|Large - Cap Stock||Blue chip stocks such as Coca-Cola||Low||Low|
One can immediately notice there is a clear risk-return trade-off. Assets that provide a higher level of return are also associated with taking higher risk.
Let’s look at a few hypothetical profiles and portfolio examples
Profile 1: Young, low savings, high-risk appetite, zero experience with investing.
Such an individual will be tempted with the thought of making it big in the stock market. However, with the zero level of experience, it will be best to start slow and build up the amount of stocks owned, or they might end up losing all of their savings.
Profile 2: Retired, substantial savings, medium-risk appetite, good investing experience.
This individual has a low-risk appetite, but they are also an experienced investor and will thus likely make informed decisions. Hence, the best way forward would be to have a portfolio weighed heavily towards stocks.
Such advice is the opposite of what is traditionally relayed to investors, but age is not the only factor when deciding on a portfolio mix. For example, Warren Buffet and other prominent fund managers are far beyond their retirement age but deal with stocks only because they are well acquainted with the art of investing.
There are literally thousands of hypothetical examples that could be illustrated, but such an exercise is trivial and beyond the scope of this article. You should understand only one concept at this point. YOU are the only person who knows the best asset allocation for you.
Asset allocation requires constant tweaking to your investment portfolio
Identifying the best asset allocation is the first part of the puzzle; next, one needs to ascertain the rebalancing requirements. In other words, the value of the securities in your portfolio will likely change and as a result, so will the weights allocated to each of those securities. For instance, imagine that you had invested half of your money in T-bills and the other half in stocks of Facebook (FB) at the time of its initial public offering in 2012.
Facebook’s stock has skyrocketed, but the value of T-bills has more or less remained the same. Therefore, your portfolio will have a more than appropriate weight devoted towards stocks. Thus, it would be best to sell FB stocks and buy T-bills with the cash generated to attain the initial portfolio balance. An over simplified example, but useful for gaining a good grasp on the concept of portfolio re-balancing.
The 100 year rule and asset allocation
Finally, a discussion on the best portfolio balance will not be complete without some insights on the 100-years rule. According to this rule, the percentage of stocks that you should hold is equal to 100 minus your age. So, if you are 40 years old then, you should invest 60% of your funds in stocks.
Lets look at the logic behind this rule. Stocks on average provide the highest rate of return over a long period of time. This is why young people are encouraged to buy them. BUT! There is a big flaw in this rule, something that was already mentioned before. This rule assumes that age is the only factor to consider.
Moreover, it ignores that fact that bonds follow 30 year cycles, high returns for 30 years and low returns in the following 30 years. The 100-years rule gained popularity when bonds were in the high returns cycle, definitely not the case today.
In closing, and a reiteration of the main message, focus on your profile instead of concepts such as the 100-years rule. Also, instead of searching for the holy grail of the best asset allocation, focus on gaining education and experience. Indeed, if you become a master stock investor, this said education and experience would trump any asset allocation strategy.