In the previous article: The Importance of Strategic Portfolio Allocation: Maximizing Returns and Minimizing Risks, we discussed the how asset allocation is the single most important decision that can impact your portfolio returns. Based on studies, if done correctly, it can boost returns, reduce risks while meeting your investment objectives.
Beyond the steps provided in the article, how do we individuals make use of free professional resources to strategically allocate our monies for our retirement and investment? We have been researching on this for the past weeks and here is the 3-minute condensed version of our research.
1. Establishing baseline
A perennial question that plagued both professional investors and academics was how to construct an optimal portfolio that provides the most returns with the minimal risks.
The answer was an idea of a market portfolio – the best portfolio is the average portfolio held across all investors in the world. That is, a portfolio of all risky assets proportionally weighted by their market capitalization should offer the maximum returns and least risk as it benefits from the least unsystematic risks from diversification effects.
However, even with this idea, in reality, not all risky assets can be easily accounted for, aggregated and be invested in with low costs. Not until now, where technology has made it possible to account for these assets, much more assessible and efficient to invest in.
The market portfolio is becoming increasingly relevant to investors as their portfolio baseline to calibrate their investments and reach their investment objectives. It forms crucial basis for important decisions such as under/over-weighting certain investments.
From State Street Global Advisors, this is the baseline for investors.
With the baseline established, this gives us important information to get started.
2. Asset classes
Few details from the chart above that are obvious: the various asset classes considered in the market portfolio, and its respective allocation. These have important insights and we will explain them here.
As common media often mention, there are typically few asset classes such as bonds, equities, cash, commodities and real estate. These are the major groups. However, as seen above, there are 9 distinct categories and some of them are further breakdowns of the asset classes that we know. For example, Government Bonds, IG Credit, Inflation Linked Bonds and HY Bonds are a subset of bonds. Whereas for commodities and real estate, there are no further breakdowns.
2 implications here:
- Bonds have the largest allocation in the market portfolio where notably, some of its subsets are specifically called out. With the discussion on baseline portfolio in point 1, bonds cannot be ignored as an asset class and it is also imperatively to consider diversifying into its specific subsets. Any adjustments and active bets should then typically be made from the baseline portfolio.
- The baseline portfolio also has low investment in gold and real estate. There are some interesting inferences which we draw here: there seem to be some penalties for liquidity risks – investments are low for private equity, gold and real estate which have low liquidity; there are still diversification benefits when investing across asset classes.
Trends provide important context on how things have progressed. Few key information here:
- Despite some dips occurring during market downturns, the market portfolio has increased significantly and looks to be growing more. This can be inferred from the increase in money supply as the Fed pumps more money into the system. Inflation is definitely real and evident here.
- Alternative assets which have real limited supply, instead grew at marginal pace compared to equities and bonds. The growth indicates inflation and also the impact of dynamic supply with Fed printing program. It proves the point that choosing the right asset class that moves with increasing money supply will benefit investors.
4. Why it is important
Consolidating what we have discussed above,
- The global market portfolio is the baseline portfolio which investors should consider as it is the optimal portfolio. The screenshot shows the allocations as baseline. For a professional investor, any adjustments can be made from this to reflect an individual’s active bets on investments
- Adjustments on asset classes are deliberate bets on investment trends and getting these right will give the additional boost in investment returns. For example, being invested in just equity, gold and IG credit bonds will experienced significant growth compared to other asset classes.
- Historically markets have been going up but dips are inevitable and can stretch for extended periods without warning. Hence the risk is actually the maximum drawdown in a single period. In fact, assets that grew the most are most susceptible to such large drawdowns.
- Without a magic glass ball, it is crucial to diversify into various assets to reduce risk while ensuring that you are sufficiently covered and can still capture the explosive growth of certain assets.
5. What’s next
From the above, there are some next steps that we are also doing for own portfolios:
- Review portfolio allocations and make sure that it is future-proof to meet our investment objectives. The most important is to ensure the relevant asset classes are invested in.
- Making informed decisions and active bets by overweighting certain allocations in my portfolios. In fact, I may even consider splitting my portfolio into 2 sections: a passive aspect to ensure that I am at least earning market rates while an active aspect allows me to satisfy my “investing” tendencies.
Guides are useful to read but templates put action into context. Family and friends have been asking how I track, monitor and review my finances. I created some personal finance templates for my personal use and found them to be helpful in making my plans/actions more concrete.
While I am sorting them out and including instructions, you can find those that are available here: https://pocketmint.gumroad.com/.