Building Better Portfolios
The past 18 months have proved challenging for investors of all stripes. Until recently, the entire experience of even the most seasoned investors was built exclusively in a period of secular disinflation. For most people this meant some version of a balanced portfolio of equities and bonds did a decent job of preserving and growing the real value of their wealth. Indeed, the entire industry is built around this framework with the ratio between the key asset classes determined by an assessment of the desired level of risk. The less risk, the higher the bond allocation.
The issue today is that there is significantly more uncertainty ahead. There could be a deflationary collapse, global war, monetary inflation or more hopefully, something in between. When constructing a portfolio, we need to be able to create a tolerable outcome in a whole range of scenarios because we genuinely cannot know what will transpire. The future path of events is, to use a ten-dollar word, stochastic. It depends on actions and choices we can’t even frame today, let alone predict the implications.
Is there anything we can do to improve upon the basic portfolio construction to improve our risk-adjusted returns and leave us better placed to prosper financially whatever the future holds?
First let’s lay down some basic assumptions; Over long periods of time, holding financial assets gives a better return than holding cash. This is particularly obvious in respect of physical bank notes which get eroded over time by inflation but is also true of instant access cash deposits which tend to attract poor interest rates. There are times when very short-term cash or cash-like instruments do well, but this tends to be during periods of tightening monetary policy like we have seen in recent times.
Secondly, the fundamental premise that within financial assets, bonds are less risky than stocks, is sound when we think in nominal terms. However, this may not be the case over long periods when inflation is the most likely threat to the real value of the portfolio. The problem for most investors is that neither equities nor bonds tend to do well during structural inflation.
When considering building a portfolio that is likely to be robust under different economic conditions, we need to add assets that can do well during inflation. These include commodities, gold and inflation-linked bonds. Note that we are not making a forecast inflation will remain elevated on a structural basis. We are simply saying that a portfolio that includes these assets is better balanced to the different potential inflation regimes.
Everything mentioned so far relates to different assets that one can own, each with some level of expected return over time. The final category to consider is return streams derived from manager skill (or alpha as it is known within the industry). The returns from owning assets can be considered as quite reliable over long periods but depending on the exact asset in question, quite unreliable over short periods. Generating alpha is difficult, often transient and expensive to access. Nevertheless, if allocated to thoughtfully, it can contribute a diversified, uncorrelated source of returns that improves portfolio risk-adjusted returns. Commodity trend following strategies for example offer the potential to capture some of the major moves that can occur in this asset class but without committing to the long-term low returns of a buy and hold approach.
The key to portfolio construction is not optimising around what you think you know about the future, but about understanding that you need a portfolio that can deliver across the diverse range of outcomes that are possible in today’s uncertain world.