Asset mix determines most of the performance of a diversified portfolio. At BluePrint Investing, we focus on helping clients better understand their own risk tolerance and how that translates into the optimal asset mix for them.
Stocks vs. Bonds
The biggest driver of a given portfolio’s risk and return is the proportion of the portfolio invested in stocks versus bonds.
Stocks are the growth engine of the portfolio. Most portfolios need the growth attributes stocks offer to outpace inflation and meet their own spending goals.
With stocks driving growth, we believe the main purpose of bonds is to reduce overall portfolio volatility. Therefore, we advocate investing in lower risk bonds. This can be achieved by investing in shorter term, higher credit quality bonds with minimal currency risk. Higher credit quality bonds maintain value (or even appreciate) during times of market distress. Bonds with lower duration help avoid volatility associated with expectations of higher interest rates or inflation.
An investor’s appetite for risk guides their asset allocation. We discuss prior market declines with clients to help drive home an understanding of the potential risk embedded in a given portfolio. To earn the high returns associated with higher risk, an investor has to remain disciplined (i.e. avoid panic selling) during times of market uncertainty. We believe the best way to maintain this discipline is to understand in advance the wide swings that a portfolio will inevitably experience.
Asset Mix Within Stocks
Once the bond allocation is determined, we apply a factor-tilted allocation within stocks. We consider the worldwide market capitalization-weighted stock portfolio (in other words, virtually all of the stocks available globally). The market capitalization weighted portfolio is highly liquid, with little turnover (translating into lower costs and taxes) and low fees. It is the most efficient structure that gives investors access to equity returns (one example benchmark for the market capitalization portfolio is the MSCI All World Index). From here, we deviate from the market capitalization weighted mix based on several considerations, including factor exposure and risk management. Below we outline where and why we deviate from the market capitalization-weighted portfolio.
As of this writing, the US represents approximately 55% of the equity market capitalization weighted portfolio while 45% is represented by foreign stocks. However, we advocate maintaining the US stock exposure slightly above this level in order to reduce currency risk and increase the correlation of asset performance with the cost of living in the investor’s home country.
Small capitalization stocks in the US represent only a fraction of the US market capitalization weighted portfolio. We advocate increasing that exposure for two reasons.
First, small stocks offer additional diversification to the portfolio. While they represent a small fraction of total market capitalization, they represent the majority of the number of companies. More importantly, they offer lower correlation with stocks of other countries than do large cap stocks. For example, many large US companies are multinational corporations. Their performance is therefore more correlated with foreign markets (correlations between US stocks and foreign stocks has increased in recent decades; many believe this is due to increased corporate globalization). Small US companies typically do not have as much foreign exposure and therefore offer greater diversification.
Second, as mentioned, the Fama/French Three Factor Model demonstrates that small company stocks have higher long-term expected returns than large company stocks, in return for higher risk. Therefore, by increasing the allocation to small capitalization stocks, we position long-term client portfolios to benefit from the “size premium”.
As mentioned, the Fama/French Three Factor Model also demonstrates that lower priced “value” stocks have higher expected returns than higher-priced “growth” stocks. Therefore, we increase the allocation to value stocks as well. However, like the size premium, the value premium is not a free lunch. Greater long-term return involves greater risk, and value stocks often represent out-of-favor companies that may be facing financial distress or general business difficulty. Therefore, it is important to understand the tradeoffs of these “value tilts”.
As mentioned, we also advocate adding other asset classes such as REITs to the portfolio to benefit from its unique diversification benefits. Under certain conditions, for example, REIT performance may be favorable during an inflationary environment.