Optimal Portfolio Allocations

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.

  1. 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.

  2. 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.

  3. 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. :joy:

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Another great post @Marsares :+1:

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Some good suggestions here. It’s really each to their own.

I’m derisking my portfolio now - selling at a profit and moving 50-60% of my portfolio into Gilts and 7-10 year US Treasury notes. While at the same time with 10-15% of my portfolio making a number of small bets - mainly in biotech with the hope that one or two hit big.

Very interesting post above @Marsares thanks - would you be able to point the non-expert reader at anything that unpacks this a bit more? I ask because most of what I’ve read about asset allocation seems to still take 60/40 (or variants, 80/20 and so on) as foundational.

60% equity / 40% bond is still the norm for the retail investor, partially because its been the norm for so long and advisors and retail investors themselves have grown up with this as it has stood the test of time.

But also perhaps because alternatives are much more difficult to access for retail investors than it is for institutional ones. Institutions typically lead the way though, and in years to come I suspect alternatives will become much easier accessible and portfolio allocations for retail investors will shift as a result.

There’s an “all weather” portfolio by Ray Dalio, which he revealed in Tony Robbins’ Money book. I don’t follow the strategy though (yet) but it appears that he may have been “right” more often than “wrong” as he’s consistently delivered returns over the years - especially in times like today:

CNBC:

A typical portfolio might be split between 50 percent bonds and 50 percent stocks, but Dalio argues that isn’t really diversified in “Money: Master the Game” by Tony Robbins.

“When you look at most portfolios, they have a very strong bias to do well in good times and bad in bad times,” Dalio says in the book. To avoid your portfolio simply rising and falling with the market, his advice is to spread out and balance the risks of each investment.

Here’s his breakdown for what a well-diversified portfolio might look like, according to the book: 30 percent allocated to stocks, 40 percent to long-term U.S. bonds, 15 percent to intermediate U.S. bonds, 7.5 percent to gold and 7.5 percent to other commodities. (The portfolio does need to be rebalanced annually, he adds.)

This comes from:

He’s got access to to the bond and commodities markets while retail investors may have to use proxies, that follow them closely. Not sure here.

This is not an investment advice.

This is a book reading advice. That book where the portfolio was revealed is one of the best investments and it costs less than £10. It’s a long read though. The guy interviewed billionaire investors because he himself is a billionaire and is good friends with some of them. He coaches some of them. The 2008 crisis and the aftermath were some of the reasons why he wrote the book for the masses.

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Thank you all for the above recommendations, I’m much happier with where things are at right now with my portfolio.

Thanks for this great post. Do you have a link for these asset allocations?

  • 1997 60% equity, 35% bonds and 5% alternatives
  • 2016 split of 48/28/24%

Is there a website where this is discussed with years and concrete numbers like yours? I would be keen to see this gradual change over the decades.

There is a great playlist from MIT’s Andrew Lo where he sits down with all the greats in finance to discuss the perfect portfolio, definitely worth a watch.

Link to interview playlist:

Great summary! At the end of the day there’s no such thing as an ‘optimal’ portfolio allocation as it depends on market characteristics at a point in time as well as personal circumstances

I have come to realise that the UK does not have an investment platform that allows you to select your funds & allocation percentage with a simple slider option - then set up regular payments hassle free.

You have platforms which offer OEIC funds & trackers for only the platforms yearly cost but £11.99 share & etf fees and no regular payment schemes which make sense for £250 pm.

You have platforms which offer free-trading but zero regular allocation tools.

You have a platform which offers free-trading with allocation tools but no access to low cost OEIC funds etc…

You have platforms which have selected your investments for you that you can not alter yourself.

Its been years and still no real breakthrough in the UK to personal allocation tools. Regular direct debits… Simple portfolio allocation.

Its reeeeeaaaaaaalllllllyyyy tough to set and forget and I thought this would have been addressed by now…

There aren’t sliders but plenty of the traditional platforms will let you set up monthly buys of funds based on predetermined percentages.

I had an ISA account with Charles Stanley Direct and I did just that, I haven’t used it on my HL account but I assume that does does offer it as well.

@adam has said a few time that this feature will be coming, called autopilot. It was planned but it looks like it had been put in the back burner in favour of EU expansion. For it to work to its best potential UK fractional shares would be needed.

It fits perfectly into the FT ethos of long term relationships with this customers and encouraging regular steady investing.

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I would like some feedback on my portfolio and investing strategy. I have been investing for about 2 months with Freetrade.

I would say my main strategy is investing in ETFs and only investing in individual stocks if I understand them very well. I personally do not believe in needing to diversify, if you buy a few good businesses then there’s no need to diversify, if you’re investing in the long term.

I have only invested in Microsoft and Tech ETFs, and would invest about £250 each month. I’m a software developer, and tech is the only thing I understand very well and that’s why I chose to aggressively invest in it. I also plan on expanding and investing in more ETFs in the future, but right now these two are the only ones I’m comfortable in

What are some of your thoughts on my thought process and strategy. Is it flawed? Anywhere you think I could improve on?

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40% of IITU is comprised of Apple and Microsoft ( 20% each ) so there’s some crossover with your Microsoft holding.

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wouldn’t say it’s a bad thing, but you have more exposure to MSFT, so if something was to go tits up, it would hurt both your positions

That’s a good point. Is the crossover a bad thing? Does it mean my portfolio is inefficient?

That’s true, but I doubt it would with Microsoft currently. Microsoft may go tits up in the short term, but long term I think they’ll be fine.

MSFT a hold for life I think…especially with their research into printing data on to glass.

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I agree. I saw that and I think it’s amazing what they’ve been able to achieve. Also if that glass technology gets better, it would further improve their cloud service Azure.