It's important for investors to have a balanced portfolio. But what does a balanced portfolio look like? And what sort of assets should it include?
One of the things that setsrockwealth apart from other financial advice firms is ourevidence-based investment philosophy. But what does that actually mean in practice?
Essentially it means that the way we invest our clients’ money is informed by independent, time-tested and peer-reviewed evidence. That’s how, for example, the medical profession operates, and financial advice should be no different. Believe it or not, though, many advisers ignore the basic principles of academic finance altogether.
One of those key principles is called Separation Theorem, and that’s what we’re going to explain in this article. So what exactly is it? And what are the implications for investors?
Separation theorem was posited by an American economist namedJames Tobin, who was awarded the Nobel Prize in Economic Sciences in 1981. Essentially it states that an investment portfolio should consist of two distinct parts, the risky part and the safe part.
The risky part of a balanced portfolio
The aim of the risky part of a balanced portfolio is to generate the highest possible returns. The general consensus among academics is that this should primarily consist of the so-called total stock market, in other words, a diversified portfolio of equities from every sector of the economy and every region of the world.
Why equities? Well, although prices can be volatile in the short term, and can sometimes fall sharply, equities have historically delivered significantly higher returns than other financial assets in the long term.
There might be an argument for putting other asset classes in the risky part of the portfolio, property or commodities, for example, but it’s generally agreed that equities should be the main driver of returns.
The safe part of a balanced portfolio
What about the safe part of a balanced portfolio, or the Risk-Free Asset as Tobin called it? Again, there’s some debate among academics and financial practitioners about the precise components, but we atrockwealth favour government bonds. These are more commonly known as gilts in the UK and as Treasurys in the US.
So why government bonds? Well, no investment is entirely safe, or risk-free, and that includes government bonds. There have been rare exceptions, September 2022 was an example in the UK, when values have fallen sharply. But, generally speaking, government bonds are a relatively safe investment. They do, of course, generate returns, but their primary role in a portfolio is to offset the riskiness of equities.
The other advantage of government bonds is that they generally have a negative correlation with equities. In other words, when one zigs, the other tends to zag; when equities go down in value, gilts and Treasurys usually rise in value.
Why two parts?
Why then do you need both parts of the portfolio? It’s a very valid question, because, if generating the highest possible return were all you were interested in, you could dispense with the risk-free asset altogether.
Having a portfolio that’s 100% invested in equities might well make sense if you’re a new investor, your portfolio is small, and you have plenty of time to recover from a crash or sharp correction.
But it’s a different story for more mature investors. It’s not that unusual for global equity markets to lose 40% of their value. Say you’re aged 65 and on the verge of retirement, and you have £1 million in your pension pot. To see that pot shrink to £600,000, perhaps in just a few weeks, could have a devastating impact on both your state of mind and your future plans.
That’s why almost all investors over the age of 40 will have a risk-free asset like bonds or cash as part of a balanced portfolio. Having that balance provides them with a smoother journey towards their investment goals, allowing them, if you like, to sleep more soundly at night.
Finding the right mix
A helpful way of looking at this is the whisky-and-water analogy. Even the most experienced whisky drinkers prefer not to drink it neat, and it’s the same with equities. The key is to find the balance of whisky and water, or risky assets and safe assets, that’s right for you.
That balance depends on what we call your capacity for risk. Working out your risk capacity is crucially important and ideally requires the help of professional financial planners like ourselves.
The three key questions are:
How much risk do you need to take? After all, there is no point in risking money if you don’t actually need to.
How much risk can you afford to take? Putting more money at risk than you can afford to lose, particularly when you’re close to retirement, would be extremely foolhardy.
How much risk can you tolerate taking? We’re all different. Some of us would be traumatised if our portfolio suddenly fell 20%, while others wouldn’t bat an eyelid at 30%. Ascertaining your personal risk tolerance is very important.
Once you, with the help of your adviser, have correctly answered those three questions, you are then in a position to work out how much of your money to put into the risky part of your portfolio, and how much into the safe part.
Is YOUR portfolio built this way?
That, in a nutshell, is what Separation Theorem, what it means for investors, and what a balanced portfolio looks like.
In short, it’s the simplest and most effective way to build a portfolio.
Is this howyour portfolio is constructed? If not, why not come and talk to us?
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