The ‘balanced’ portfolio has become an institution in the financial world. Equities and bonds are the main ingredients and the ‘mix’ determines the categories of balanced funds commonly used. Here we discuss this approach, and look at another option. The traditional model Words like ‘conservative’ or ‘capital preservation’ signal a low weighting to equities, around 20% to 30%, while ‘balanced’ usually means 40% to 60% in equities, and ‘aggressive’ or ‘growth’, can be as high as 90% in equities. The equity component is the main determinant of the return and volatility of ‘balanced’ portfolios. Property is another asset class often used, but generally speaking this will consist of listed property companies, and I would argue listed property companies are just a part of the equity market. Cash is of course another asset class, but for the purpose of this article, I will assume cash is part of the bond allocation. Equities provide high long-term returns, but are volatile. Losses in equity markets can be severe, leaving investors in the red for years on end. Bonds provide more predictable returns because they (the returns) mostly come from regular interest payments called ‘coupons’. These payments remain the same throughout the life of most bonds. Lower risk bond prices fluctuate based on interest rates, but the fluctuations are much lower than equities. Investment grade corporate bond volatility is around 2% p.a. versus 12% to 15% for equity markets. Traditionally advisors and institutions manage portfolio risk by their bond/cash weightings. The more conservative the investor, usually based on age and circumstances, the lower the allocation to equities. The logic behind this approach is based on the fundamental principle of diversification. Diversification depends on an asset’s behaviour in certain market conditions, particularly when losses are involved. When you have an asset that is losing money, something that provides ‘diversification’ will be making money or at least losing far less, and this pattern is strong, that is, you can rely on this inverse relationship. Among other things, the chart below shows the Schiller P/E, a measure of how expensive equities are, and the US 10-year yield inverted, showing bond market valuations. Over the last 100 years, bonds have been a great diversifier. The exception is the period 1960 to 1980 when ‘real’ bond prices fell -26.2 %, and equities rose just 74.3%, or 2.7% p.a. These were the inflation years, and while equities rose, they became increasingly cheap. What is particularly interesting for us, is that in most people’s ‘investing lifetime’ (post 1980), we have been in a golden age for bond/equity portfolios. By the early 1980’s both were extremely cheap. Since then, bonds have…

To continue reading...

CLICK HERE NOW

Blurred Text