Well, of course, there is no perfect portfolio post-pandemic, but I wanted a bit of alliteration so there it is.

The closest we can get to perfection is the optimised portfolio. But optimisation is all about finding the best balance of risk and return for a portfolio of assets – and risk lies in the future. Therein lies the problem. Also, what is the ‘best balance’ is dependent upon your attitude to risk. In this set of blogs I want to take you on a journey through the process of analysing, optimising and tactically re-balancing our asset allocation.

Most investors don’t optimise; they diversify in a slightly more ad-hoc fashion. Some diversification is better than none at all, but the results can often be too focused on returns and certainly skewed by behavioural biases rather than indisputable facts.

In other words, investors are not all rational, nor risk averse – as they should be

In this, the first instalment of this portfolio construction blog, I want to show you how simple it can be to achieve the benefits of a diversified portfolio and give you some pointers as to how to invest in these assets.

Step 1: Diversify

In 2010, pension funds and other large institutional investors were knocked out by the impact of the financial crisis; or were they?

If you look at the returns / risk data in the table below, an investment in large US equity (the US being a good global equity benchmark) would have still achieved an 11.2% average annualised return. Even with -37% in 2008! The problem is, of course, that if you had invested in all “S&P 500” stock and you were retiring at the end of 2008, you would be 37% worse off than retiring a year earlier: it’s too much risk to take.

So we start to look at diversifying our investment portfolio. It’s the closest thing to a free lunch you’ll ever get in the investment world!

An ‘ad-hoc’ diversified portfolio over the same period would have kept those same investors in line for a decent return of 10.9%pa – marginally below the 11.2% of the S&P – BUT with a much-improved risk exposure, and a reward/risk ratio of 1.09 (anything over 1 is extremely good). A much more efficient portfolio.

Diverse Portfolio returns versus S&P 500 index, 1975 to 2010

S&P 500
annualised return 11.2%
standard deviation 17.0%
return / risk 0.66
Diverse Portfolio
annualised return 10.9%
standard deviation 10.0%
return / risk 1.09

How did I pick the diversified portfolio? Well, I took a fairly arbitrary play on the “60/40” rule of thumb that is illustrated in many texts. 60% invested in riskier assets (equity of all sizes, domestic and overseas; real estate; commodities; EM) 40% in less risky (bonds and treasuries). So, it’s a well-spread mix, in line with many long-term strategic allocations.

But what happened after 2010? The data tells a different story, as shown in this table.

Diverse Portfolio versus S&P 500, 2011 to 2021

S&P 500
annualised return 13.3%
standard deviation 13.4%
return / risk 0.99
Diverse Portfolio
annualised return 6.9%
standard deviation 9.1%
return / risk 0.75

Is this poorer performance over the last decade an aberration? Or are markets and economics experiencing some longer-term structural changes? If so, what should we look out for in the coming decade? And how can I address my concerns about the current market environment?
Rest assured – diversification still works fine: that’s a fact. But key questions to ask here are:

  1. Was the portfolio properly diversified in the first place?
  2. Was the portfolio optimised, or just diversified?
  3. Even if I optimise based known historic data, how does that relate to what’s to come?

Step 2: Check you are properly diversified

The problem I have with this choice of indices is the lack of diversification (i.e. concentration). This is very apparent in the S&P500, where the largest 5 stocks make up over 20% of the index (as of March 2021). And on average around 14% for the last 10 years. These 5 have contributed 26% return pa since 2011. 

Wow! – that is a significant concentration bias, and a good reason that my diverse portfolio underperforms the S&P500.

For transparency, my ‘diverse’ portfolio actually comprises 30% in investment-grade corporate bonds; 20% in large-cap equities; 10% short dated treasuries; 10% international equity; 10% mid-caps equities; 5% small caps; 5% emerging markets; 5% commodities; and 5% in real estate investment trusts. The data is based on actual ETF performance net of ongoing charges. They are a true investable portfolio. All available as iShares ® .

However, another diversification issue comes in – GSCI (commodity index). People think commodities and think oil and gold. The GSCI composition is production weighted, so energy and agricultural products dominate. Oil-related products are over 50% of the index. Gold, the premium store of value and best performer when there is a ‘flight to safety’ makes up less that 4% of the index. So, my portfolio is not hedged in times of economic turmoil, such as….er…a global pandemic! Again, a significant reason the diversified portfolio has not performed well over the last 10 years.

Perhaps I should consider wine and whisky? Potentially as an investment too……..

Step 3: what would an optimised portfolio look like?

I’m going to leave this final step in my analysis until next time. There’s a few steps to talk through here – including the mechanics of optimisation – and you have enough food for thought for now.

If you’re interested in finding out more about our popular investment and wealth management training programmes in which we show delegates the simplicity and power of investment diversification – then contact us today.