We all enjoy when our portfolio skyrockets in a relatively short timeframe; let’s say six months, a year, perhaps two. Yet, it is important to remember that over the longer-term, the principal driver of your portfolio performance is determined by the allocation among different asset classes. Although we know this yet we are often tempted by our exaggerated ability to precisely time the market—it really doesn’t work over the long-term.
Here’s a primer that we all know but a refresher may be helpful:
Step 1: Taking a strategic of top down view—Asset allocation should precede the selection of individual investments/instruments
The main folly committed by countless investors is building their portfolios by selecting individual investment opportunities in the form of single securities or funds. The overall proportions they hold in the various asset classes (equities, bonds, etc.), however, are often not a priority, yet they are critical in determining the portfolio’s overall risk and return characteristics. Please establish the asset allocation and then select suitable instruments.
Step 2: First diversify among asset classes then within them
It is important to combine asset classes—evidence has shown that some asset classes will perform better in certain economic conditions while others perform better in different conditions—this can increase return while reducing risk. While different asset classes may both produce positive returns over the long term, it is highly unlikely that will move in lock-step. Take for example, US equities and US high grade bonds, which have delivered 7.5% and 5.2% per annum respectively for the past 10 years. In 2008, however, US equities lost 37% while US high grade bonds returned 8%. Portfolio diversification is achieved by combining distinct asset classes to reduce overall volatility while maintaining long-term performance potential. A solid portfolio is one that provides the best risk adjusted rate of return.
Step 3: Only assume risk for an expected return
As investors, we should only take on risk when we think we will be reasonably compensated for it—we make these choices subconsciously in our daily lives and it is important to carry these forward to our investment portfolio. We must assess each asset class in the value it brings to our portfolio. For example, foreign currencies require watchful consideration because if you do not expect gains from converting into them, you should remove the risk of loss through hedging.
Step 4: Manage your biases
Most of us are more comfortable investing in in companies and opportunities that we are directly aware of and are close to home. There is little doubt that owning such assets can give us comfort, however we should be careful not to do so in extreme proportions as it is will compromise diversification.
Step 5: Establish realistic expectations
Although we are astute intellectually, emotionally none of us are truly comfortable when our portfolio declines in value. However, because most cash rates are close to zero currently, and many government bonds yield less than 2%–3%, if we want to achieve a higher return we may have to assume additional risk. It is really hard to consistently achieve target rates of return over periods of a year or less. It is a different context as we think about our investments over a longer time frame (five to ten years), and it is reasonable to expect that asset prices tend to revert to a fair defensible value, which makes portfolio returns more predictable.