Portfolio allocation ultimately is about diversification, which is about risk appetite. There are many lenses that you should consider allocation through:
- Am I diversified enough across industries?
- Am I diversified enough across small/mid/large cap?
- Am I diversified enough across geographies?
In its strictest form, however, allocation is the choice between different types of asset classes. Modern asset management began in the 1950’s with the Modern Portfolio Theory and the Capital Asset Pricing Model which, when combined, found an “efficient frontier” whereby the mix of 60% equity and 40% bonds provided the optimal mix of risk vs return, providing on average a return of c10% per annum.
This 60/40 model was so successful, it became know in the industry as “set it and forget it” and was the dominant model for 50 odd years. The dot.com bubble changed this, resulting into three strategies to boost returns, but with less risk and at lower cost.
Investors sought to reduce the fees they paid by seeking out lower-cost approaches to obtain their equity market exposure. This gave rise to the ongoing shift from active management towards passive, and resulted in the popularity of indices and ETFs.
Institutional investors shifted assets from high-risk equity strategies to strategies that offered equity like returns at bond-like risk profiles. This gave rise to hedge funds.
They sought to take advantage of longer-term investment horizon to seek illiquid assets that could offer uncorrelated return streams to their portfolios, things like property, private equity, venture capital funds, SME loans, etc.
All this led to the gradual breakdown of the 60/40 model, accelerated by the Yale “endowment model”, which invested more heavily into alternative asset classes.
It all led to a shift in AUM allocation, with in 1997 60% equity, 35% bonds and 5% alternatives, to a 2016 split of 48/28/24%
Therefore, you can take as a starting point this split for your own portfolio, ensuring that you have a similar coverage over equity, bonds and alternatives. From there, you adjust according to your own risk appetite.
You can try to get the optimal allocation across equity by picking a meaningful number of stocks. In 1970, Lawrence Fisher and James H. Lorie released "Some Studies of Variability of Returns on Investments In Common Stocks“ published in The Journal Of Business on the “reduction of return scattering” as a result of the number of stocks in a portfolio. They found that a randomly created portfolio of 32 stocks could reduce the distribution by 95%, compared to a portfolio of the entire New York Stock universe.
The question that then arises is whether you are comfortable to pick a minimum of 30 stocks and keep an eye on them. Warren Buffet argues to “Consistently buy an S&P 500 low-cost index fund," as one of the best ways to grow wealth. “I think it’s the thing that makes the most sense practically all of the time.”, he said. I am of a similar opinion, most people won’t outperform the stock market themselves, and it’s best to put a high % into a low cost ETF.
Bonds are much easier to juggle yourself, you just pick them across sufficient geographies and you should be covered. Alternative asset classes are more difficult to get by. Private equity typically isn’t available to private investors and startups are not yet listed on the stock market. Your best bet is to get REITs and invest through those in property. Crowdfunding is another option to access alternatives, and although the tax benefits are attractive through SEIS and EIS, failure rates are high.
Therefore, to cut a long story short, theory has it you should have 48% equity, but wisdom then tells you to invest the vast majority of that in ETFs or other passive, whilst you also hold 28% bonds (government most likely) and the remaining 24% in alternatives (property in the absence of much other options for alternative to retail investors).
Personally I’m a happy go lucky, FOMO YOLO kind of guy and throw caution to the wind as my risk appetite is high with regards to FreeTrade as it’s money I can afford to lose. My portfolio on FreeTrade is pure equity, although 70% ETFs, with the rest in individual stocks.
However, this is balanced off by my other investments. I have a sizeable crowdfunding portfolio, but also churn the majority of investments into more traditional vehicles like a company pension, an offshore private pension and an offshore trust fund. These balance out my risky approach on FreeTrade.
Edit: maths were failing me somewhat, thanks to Raul for pointing out. Now off to get more coffee.