After starting my own investing journey I wanted to learn more about building a portfolio that would give me decent returns whilst minimising risk. My portfolio incorporated some diversification but I still had questions around what proportion I should hold in various asset classes (e.g. stocks, bonds, etc). Some people hold their savings solely in cash, some in a mixture of cash, stocks and bonds, whilst others add even more into their portfolio (e.g. precious metals). The Intelligent Asset Allocator: How to Build Your Portfolio to Maximize Returns and Minimize Risk by William Bernstein came highly recommended for helping me do just that.
To have an idea what you’re doing on this journey, you will need to learn and that means reading. Getting started is one thing (anyone can do that) but getting the best return whilst minimising risk is another. Although written from a US perspective the concepts discussed around diversification still apply.
What this book can do for you…
- Give those leaving their investment decisions to others a helping hand in starting to make their own decisions.
- For those with existing portfolios in one basket it will provide diversification options.
- Provide an understanding of the concept of re-balancing (i.e. selling high and buying low – the opposite to what the masses do). This is essential in maximising your return.
- Demonstrate how you pay for the convenience of having others make your investment decisions, highlighting how it erodes your returns.
What I love about this book
The “How to Read this Book” section couldn’t be truer; this is NOT a book to read all day long but should be “tackled first thing in the morning while you are still fresh. Put it down after an hour or so, and do not pick it up again until the next day”.
You will need time to wrap your head around some of the concepts (at least I did). I love the fact this outlined at the beginning as it saves hours of potential frustration.
Early on Bernstein emphasises that all important point that risk and reward are intertwined therefore we shouldn’t expect high returns without high risk. The stock market clearly shows this as huge gains aren’t unheard of but there have also been eye-watering losses. If this was the only lesson you took from the book it would serve you well.
Anything that comes your way promising high returns with little or no risk should raise a red flag. If it sounds too good to be true, it usually is.
The effect of diversification is demonstrated via a coin toss making it easy to understand. The term diversification may come across as jargon to some but the coin toss is something we all understand. So how does it work?
- You have £100 to invest.
- At the end of each year your investment will either go up 30% or decline 10% depending on the outcome of a coin toss.
- Heads, your investment goes up 30%, tails, it falls by 10%.
So after one coin toss your position will be one of the following:
What would happen if we split our money investing two lots of £50? This will mean one coin toss for each. Again, heads, the investment goes up 30%, tails it falls 10%.
We now have 4 possible outcomes:
As the table shows by splitting our money into two investments we have reduced the likelihood of losing money from 50% to 25% (1 in 4).
In summary it shows that diversified portfolios do not behave the same as their constituent assets (assuming the outcome of one isn’t linked to the other).
Applying this concept to the market, stocks may experience significant swings between gains and losses, but the introduction of bonds into the mix will offset these losses (either partially or in full) due to their regular income.
On the topic of asset allocation the inclusion of the following table serves as a useful guide in helping to determine what stock/bonds mix may work for you.
If you could handle losing 35% of your portfolio, Bernstein recommends holding 80% of your portfolio in stocks. This is likely to be the case for someone early in their working life as they have time to recover from losses. In contrast someone close to retirement is likely to have a much lower stock allocation as they are less likely to tolerate a loss.
Bernstein covers that all important concept of rebalancing, a step repeated periodically once you have decided on your allocation. The purpose being to bring your assets back to the target allocation (any gains or losses will have caused the allocation to change). Why is this important? It forces you to respond correctly to asset price changes.
“We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.” Warren Buffett
The response to a fall in asset price is to buy some more whilst the opposite is true for price rises. Can you see how this is counterintuitive? Most people buy as prices increase and sell as prices fall. As markets go through periods of boom and bust, selling as prices fall would mean losing out from the gains during the market’s recovery. Conversely, buying high will result in losses when the market takes a turn for the worse.
As the learning journey is a continuous one it’s great that the book provides a list of resources to further enhance your investing knowledge! Since the book was written there are even more, particularly online, so there’s no excuse not to do your research.
Maths lovers will enjoy as Bernstein includes some further maths sections for those who want to understand more about the mechanics of it all (not a must). If talk of Standard Deviation and Correlation puts fear in you, or you have found the above confusing, opt for Bernstein’s The Four Pillars of Investing as a general alternative.
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