Chapter 3

What are the key components of the rational portfolio?

Figure 3.1 Issues that the rational investor must take into account

Asset split in a rational investment portfolio

In creating the rational portfolio we split our assets into the lowest-risk assets that preserve capital and risky assets that have to generate returns, and combine the two according to our risk preference. In the low-risk bucket we should have the highest-rated and liquid government bonds, ideally available in the base currency of our investments.

We acquire riskier assets not for the sake of adding risk, but because we hope to get greater investment returns from them. Rational investors who know they can’t outperform the market are best off investing in a cheaply bought index tracker of world equities as their risky assets. It is a major evolution in the investing world that products tracking world equity indices are now readily available: just 20 years ago they were not.

Some books on investing involve intricate arguments about why certain geographical areas or sectors of the equity markets will outperform and provide a safe haven for the investor. On the contrary, the most diversified portfolio you can find offers the greatest protection against regional declines. Also, since we are simply saying ‘buy the world’, the product is very simple and should be super cheap. Over the long run that will matter greatly.

Figure 3.2 Elements of the rational portfolio

Someone willing to add a bit of complexity to the very simple portfolio of world equities and minimal-risk government bonds could add other government and corporate bonds (see Figure 3.2). Unfortunately, creating broad and cheap index-type exposure for bond portfolios is not as simple as for equities and there is a tendency for the products to be dominated by US and European securities, and in my view you have a very strong portfolio even if you ignore this added complexity. However, for those happy with a slightly more complex portfolio, the addition could add diversification and increase risk/return benefits.

Elements of the rational portfolio are summarised as follows:

You may have noticed that there are some investments that are not part of this portfolio: property, private equity/venture capital, commodities, hedge funds, private investments (including angel capital, etc.) and so on. Buying these asset classes requires an edge. Whether you invest in regional property, a private equity fund or buy coal, you are claiming that you know something about future performance that the rest of the world does not. Also some of those investments are similar to the exposure you already have through your broad market exposures (at a small fraction of the cost) and are often very illiquid. In contrast, the liquidity of the rational portfolio is one of its most underappreciated features.

Understand the level of risk you are comfortable with

The products that rational investors use may be similar, but the proportions are not. If you have £105 and need £100 for heart surgery in a year, your risk profile is very different from someone with £100 at the age of 30 who needs £150 40 years hence. Our needs change over time as we age or our circumstances change. The risk you are willing to take at age 60 is typically very different from what you were willing to take at 40. Everyone is different and individual circumstances will determine what your mix of low-risk and riskier assets (like the equity markets) will be. The elements of the portfolio don’t change, but the proportions of the risky assets do.

We need to gauge current market risk, but also think about less fun stuff like the risk of money in the bank, or the risk of markets heading down as badly as they have occasionally done in the past. With a large number of caveats, I want to use our understanding of the risks of the market to be better informed about risks in our investing.

Below is an indication of how you could split your portfolio into its component parts, depending on your risk levels (See Figure 3.3).

It really can be that simple. You have decided your risk appetite and allocation between minimal risk asset and world equities. Now all you need is to check your tax setup and go implement the portfolio.

Figure 3.3 Different risk portfolios

So someone with $100 to invest and a medium ‘C’ risk profile could do as follows:

If you decide to include other government and corporate bonds in the risky part of the portfolio, you would do well to do so in the proportions 75% world equities/10% other government bonds/15% corporate bonds, and you would scale that up or down as you add more of the minimal risk asset. With the added other government and corporate bonds your ‘C’ risk profile would therefore now be:

I will discuss how I came up with the allocations above. While the allocations are not an exact science and therefore do not have to be implemented in exactly the proportions illustrated, you would do very well if you implement your portfolio in a similar manner.

Of course our risk tolerances differ. Let’s say that we have $100 now and need $110 in 10 years’ time, and that we invest in the world equity markets where we expect real returns of about 5% a year. If we assume that performance every year will in fact be 5% we know that in 10 years our $100 will have become $162 and be far in excess of what we need. But that is not the whole story.

Since the equity markets are inherently risky, what can we say about the probability that we don’t reach $110? Is it 1%, 2% or 20%? The answer depends on the risk of the equity markets. If we believe our expected return is $162 are we willing to move our allocations away from risky equities and into lower-risk bonds if it meant increasing our chances of reaching the $110, but with lower expected assets (because the bonds have lower expected returns)? Some people may, for example, be so risk averse that they would rather have expected assets of $120 with a 2% risk of not reaching $110, instead of expected assets of $162, but a 15% risk of not having $110 in assets. Which of the two types you are depends on your individual circumstance and attitude towards risk.

The numbers above may look complicated, but we can use them to think about the risk of our allocations in the context of our financial planning. Investment performance at times will differ significantly from average; how different will depend on the risk we take, and thinking ahead to how we react to bad outcomes will help us prepare for any eventuality. I will discuss risk surveys, individual attitudes to risk, and disaster scenarios later in the book.

Don’t put all your non-investment eggs in one basket

As individual or institutional investors, the investment portfolio is only one out of several parts of our investing life. This is true when we consider risk, liquidity and taxes, but also when we consider the best investment portfolio.

Perhaps without thinking about it in those terms, many investors run the risk of putting all their eggs in the same basket. Someone may have a €1 million house with a €750,000 mortgage and a €100,000 investment portfolio. The investor has more than 90% of her gross assets tied up in the property market; if she were to invest in local property on top of this she would be buying more of an exposure that she already has plenty of. Similarly, if this was an Italian-based investor she already has plenty of exposure to the Italian economy. Putting her investments into Italian stocks would not diversify her exposure away from local exposure, as an investment into a broader index would.

There is a tendency for investors to be over-invested in their home markets; the British invest in the UK, Americans in the US, etc. Historically it was impractical and expensive to buy foreign securities, and perhaps the home bias has become an ingrained habit. Aim to diversify beyond the national borders. While many domestic firms may have international exposures as part of the business mix, as an investor you probably already have plenty of exposure to your home economy.

For most investors, incorporating non-investment assets in portfolio thinking is not a scientific optimisation, but rather a gut feeling. So when you consider your overall portfolio of assets and liabilities it is mainly the risk of interconnection between your assets you should worry about. Is there some event or risk that would affect all your assets in the same way? Could this event even lead to a crisis in your local bank and thus risk your deposits? Is there a way for you to diversify away from that risk in some of your non-investment assets, or are you at least making sure that your investment assets are diversified? Depending on your circumstances, factors such as your job prospects, the value of your education, a potential future inheritance, etc. may move more in tandem than you expect. A broadly diversified investment portfolio could one day be your safe haven in a nasty local storm.

Reducing tax has a large impact on long-term returns

The average individual or institutional investor should make good use of tax planning advice. The optimal portfolio and risk profile we have discussed above can be put together without too much outside help; but in the case of tax, expert advice can make a huge difference.

Tax is a constant challenge. I will describe the tax benefits of the rational portfolio, but also discuss ways to save tax generally. Considering that taxes could take a huge chunk out of your returns, it’s important to get it right.

Paying too much in fees destroys asset growth

One of the key drivers of long-term returns for the rational investor is low fees and expenses. The products involved in the creation of the optimal rational portfolio are fairly generic investment products and are cheap as a result. We are not paying anyone with the expectation that they do anything particularly clever – we are asking them to replicate an index (see Figure 3.4). Perhaps a monkey couldn’t do it, but a computer certainly could.

The world of finance seems impossibly complex when it should be simple and transparent. Lower fees are a major benefit of simplifying a complex world, but importantly this has to be done while creating a stronger portfolio. We are not doing cheap for cheapness sake, but because it is a happy by-product of the simple portfolio construction that gives us the best risk/return profile. Throughout this book I will hammer home the point of low fees. If the only thing you take away from this book is getting charged a little bit less for a financial product the next time you invest, the book and time you spent reading it will have repaid itself many times over.

The benefit of paying lower fees may not look obvious at first. It typically does not reveal itself for a long time, until the compounding of better returns are really obvious, and even then there will always be some active manager or stock picker who claimed that you missed something obvious by not investing with him. Think of it as making a little bit of money while you’re sleeping; the lower fees and sensible investment strategy should make you sleep soundly at night. However, it’s not one that leaves you sleepless with giddy excitement because of great outperformance compared to the general markets.

Figure 3.4 The simple solution

Implementation of the rational portfolio

The indices I suggest for your portfolio are extremely broad, transparent and liquid. As a result they should also be extremely cheap. The exact method of buying this index exposure depends on the specific tax situation, but since the underlying assets are so broadly traded, good products are generally available.

The past decade has seen a massive increase in the number of exchange traded funds (ETFs) and the amount of money invested in them. Similarly, index funds have had large asset inflows. Both developments are very positive for investors as it has increased choice when implementing the rational portfolio. With the greater number of product offerings, the fees charged have also declined. US-based Vanguard – one of the world’s largest asset management firms – has been a major player in the drive for lower fees and even today has among the best product offerings at the lowest prices.

Because the development of index-tracking products continues to be so strong, future product development may well provide even better opportunities. At a fee of around 0.2% a year or less for world equity products there may not be much scope to significantly improve on the annual charges. But other features like tax structures or better indices to follow may improve the execution of the rational portfolio.

Generally, as a catch-all, I call any product that cheaply recreates an index-type exposure an index tracker. This could be an ETF or index fund, but also note that just because something is called an index does not make it a good choice for the rational investor. An index of companies with CEOs named Bob is an index, but that does not make it a relevant option in achieving our portfolio.

Speculate less, sleep better!

Becoming a rational investor can be a very significant moment in the investing life of some people, and those who have spent a large part of their investing lives frustrated with their inability to outperform the markets may find it a huge relief.

So what actually happens as a rational investor? The short answer is not a lot, and that is the point. But there are some ongoing tasks that you could do or have someone help you with:

• You should see if there are better or cheaper products coming on the market to replicate the rational portfolio.
• You should consider if your risk characteristics have changed significantly, or if the world around you has changed so much that the portfolio mix no longer matches your risk profile.
• You should think about your tax situation and if there are better ways of optimising it.
• If your non-investment situation changes significantly you should consider how that affects your investment portfolio.

The points above may seem like a lot to do, but really are not. These are things you should consider irrespective of whether or not you are pursuing a rational portfolio, so there is no extra work involved.

The main non-financial benefit comes from the peace of mind a rational portfolio gives the investor. Someone who has accepted the fact that they do not have an edge should naturally be investing cost efficiently for the long term. They will not be spending a lot of time and financial resources contemplating the next hot stock tip from their golfing buddy or local tip sheet (even though the tipsters are very quick and vocal to boast about their winners). They will be doing other things with their lives and slowly get richer as a result.