Episode #39 - Perfecting your portfolio
Can this be achieved? If yes, how??
Intro:
With the audacious title “The Perfect Portfolio,” Chapter 4 certainly looks to thrill those of you who are still hanging on for all the tips and tricks William J. Bernstein has to offer. Some of these topics have been covered in an early episode on “Diversity,” but I think the way he builds it out in this chapter is worth an extra look.
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Chapter Overview:
If someone asked you to tell them, what are the MOST important things that relate to their investment portfolio, what would you say?
Bernstein sums it up into two pieces:
Asset Allocation (i.e. where do you put your money)
Timing the market (i.e. when to buy and when to sell your assets)
In a 1980s paper, Gary Brinson claimed that 90% of a portfolio’s success is based on asset allocation and 10% is based on timing (p. 107). Unsurprisingly, academics and investors alike jumped on this and suggested alternative balances that would make you more/less likely to achieve investment success. What Bernstein hammers home that I believe neatly sums up the chapter is as follows:
In other words, since you cannot successfully time the market or select individual stocks, asset allocation should be the major focus of your investment strategy, because it is the only factor affecting your investment risk and return that you can control (p. 108).
Any perusal of stock performance from the past will quickly make you think YOU could pick your own stocks - “look, it was a bad year so I would have done this” or “hey, it was a fantastic year for real-estate, I would have done that.” Each of these approaches are the beauty of 20/20 hind-sight.
I’ll close this overview with two essential items:
The amount of money you can afford to risk should lead your portfolio allocation.
Even though taking on higher risk in your younger years makes the MOST sense because you’ll have more time to recover, you shouldn’t take on too much risk at the outset of your investing career. Why? In the event that the market tanks and you had hefty exposure you will likely take yourself out of the market for the foreseeable future, which would be quite bad for your long-term investment prospects. It’s better to start with less money at risk and then increase it than start really high, get spooked, and then clear out of the market.
What should drive your portfolio strategy?
Bernstein, as I mentioned, emphasizes risk tolerance as the primary guide for the way you develop your portfolio, but what would the alternative look like? He explains, that many start with their eyes toward how much money they want when they retire, how much they need to buy a home, and how much they need to maintain their lifestyle (p. 114). These are not irrelevant to your portfolio building, but they should take a back seat to your comfort with financial risk.
The second piece that you need to consider is the relative risk that stocks might have compared to bonds. In a world where the average stock return is 7%/year and bonds are 5.5%/year, the relatively small difference would seem to guide you to away from an “all stock” portfolio.
It’s all a mind game
Often folks will imagine that they are highly tolerant for risk, but then they clear out of markets when the going gets tough. This self-control is what I’d dub the most challenging part of investing. Sticking to your portfolio plan can be super difficult. This question surrounding risk tolerance has a similar impact on whether or not you’ll hold shares in the global markets. From a market perspective, the majority of the world’s market-cap of stocks is OUTSIDE the US. A true believer in efficient markets would even say to have the majority of their stock-allocated money to outside of US companies (p. 119). Because I don’t give recommendations, I will continue to not do so, but I do think remembering these pieces as they relate to building a full and smart portfolio is super important.
Takeaway:
I’ve attached two images of “stock allocations” that Bernstein lays out that are reflective of “Charlie Cringe” who “hates investing and wants to keep it as simple as possible” (p. 124) and Wendy Wonk who “runs the computer network in the accounting department of a large company (p. 125).
Interact:
In what Bernstein deems “Step Four” of asset allocation, he suggests two sectors that he deems worthy of exploring for your own investment: REITS (real estate, covered by me here) and gold. His reason for generally not recommending sectors is the risks that the sector might become obsolete (think about investing heavily in the horse-sector without knowing about the adoption of cars). However, in the current moment, are there any sectors that wouldn’t be covered by a total market investment that you would consider essential?
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Please remember, I’m not providing professional advice about personal finance. I’ve got a lot of friends who do that and you can totally hit me up for an intro if you’d like - I don’t get any commission - just the happiness that my readers are taking their financial health seriously.