Building an investment portfolio isn’t what it used to be
If you were starting an investment portfolio today you might think again, says a UK advisory, because some of the basics have changed.
If you were going to build your portfolio from the ground up, starting today, how would you go about it?
Well, you would start by determining what kind of investor you are, how much time you have to meet your goals, and so forth.
In short, you would follow the basic steps set down in the standard book of good investing.
Except some of those steps may not lead in the same direction as they used to.
From the other side of the pond, we have an interesting approach to portfolio building.
More than a few subscribers have asked The Fleet Street Letter in London: How should one construct a portfolio?
The advisory’s chief economist, Mr. Brian Durrant, is ready to answer the question. Some of his replies you will have certainly heard before.
Yet four years of crisis have brought changes to the rules of the game, he says, and the approach to building a portfolio should change with them. We need to think again when it comes to asset allocation.
He outlines two steps to building a “well-protected portfolio” and then brings into the picture a model portfolio developed 30 years ago that appears to have stood the test of time.
A white-knuckle ride
We’re all different, says Mr. Durrant, but “the investment industry still needs to pigeonhole us.” It devises standard categories for investors.
They are: Very cautious — puts money only in savings vehicles, no equities or bonds. Income and cautious — will risk some capital to invest in higher-yielding income investments and dividend paying stocks.
Balanced — wants more capital growth, pares back fixed income investments in favour of growth stocks. Growth or adventurous — looking for high capital growth, skewed to equities rather than income.
Those are pretty much the usual designations one would get from any brokerage or analyst. Yet portfolios based on these categories may not deliver what you might expect.
Mr. Durrant looks at three model portfolios put together by the Association of Private Client Investment Managers and Stockbrokers (APCIMS). The Income, Balance and Growth portfolios have been back tested to 2005.
While there were variations among them, “the experience of all three funds has been a white-knuckle ride.” Yes, the income fund is less volatile than the balanced fund and the balanced less volatile than the growth fund.
“But in the grand scheme of things the investor experience has been pretty similar in all three cases, namely steady gains punctuated by heavy losses,” he relates.
Two important steps
“The exceptional conditions of the last four years have exposed serious weaknesses in the traditional asset allocation employed by parts of the investment industry,” continues Mr. Durrant.
There are two important steps to building a well-protected portfolio, he states, two improvements in asset allocation that are particularly important for cautious investors.
First, in the APCIMS Income portfolio, the equity portion of 55 per cent is too high for prudent investors, he says. In panic-stricken conditions, this can create high volatility. It can deliver double-digit returns, but in 2008 the value of this income portfolio fell by 16.2 per cent.
Second, all of these portfolios are “too narrow and not sufficiently diversified,” adds the analyst. None of the APCIMS portfolios have gold as a separate asset class and while they include UK and international equities, they ignore emerging markets. Diverse really does mean different.
A portfolio should have separate assets that are not closely correlated — that is, that do not move in the same direction at the same time. If they all go up at once, they can all go down at once.
So let’s re-think allocation, says Mr. Durrant. “Let’s start with, on the face of it, the crudest, back-of-an envelope asset allocation imaginable.”
A four-way split
In 1981, an American pundit named Harry Browne devised what he called the “Permanent Portfolio.” It was simple: an equal four-way split between equities, government bonds, cash and gold. The portfolio was to be re-balanced to those proportions at the beginning of each year.
This is highly controversial, states Mr. Durrant. For one thing, almost no one advocates more than five or 10 per cent in gold.
Yet when this portfolio was back-tested to 1972 using the Barclays Equities and Gilts (government bonds) data, including reinvested dividends and interest, the results proved to be “astounding.”
The average annual return of the portfolio is close to 12 per cent, with an average inflation rate of 6.5 per cent over the same period.
The portfolio had negative returns in just two years, 4.8 per cent in 1994 and 1.1 per cent in 2001. It had strong returns in two “harrowing” years — 1974, which was racked by high inflation and a huge mining strike in Britain, and 2008, the year of the crash.
In the latter year, equities lost 30 per cent and cash returned less than one, but the rest of the portfolio held up.
Thus this portfolio can prosper in times of high interest rates, when cash does well. It also thrives in times of high growth and low inflation, when equities do well. And when the economy and the pound are in shambles and equity and bond markets both sag, as in 1974, gold comes to the rescue.
In short, there are three secrets to the success of the so-called “Browne Portfolio,” insists Mr. Durrant.
First, equities do not dominate its content. Second, the assets have low correlations with each other. They do not go up and down in unison. Third, gold is an important asset class in its own right.
The writer promises more specifics on asset allocation in a future issue and we will keep an eye out for his suggestions.
In the meantime, he firmly believes that to create a crisis-proof portfolio, investors should be willing to take a second look at the basics. They are changing.
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