Secrets of Success: Divide and conquer: the optimal portfolio
Saturday 28 August 2004
Diversification, all sensible people know, is the key to an effective investment strategy. But it is a principle that is harder to put into practice than we mostly realise.
Diversification, all sensible people know, is the key to an effective investment strategy. But it is a principle that is harder to put into practice than we mostly realise. The main reason, I think, is that it is one thing to sign on to the principle, and quite another to know how much to have in different types of asset and security.
What, for example, is the right proportion of your assets to have invested in the stock market? And how much, to take the most topical example, should your financial welfare be dependent on property?
Thanks to sterling efforts of the Nobel prizewinner Professor Harry Markowitz and a generation of later academics, what we do know is that there are some clever mathematical ways of working out the optimal weights in a portfolio.
The technique of mean variance optimisation makes it possible to work out the best combination of risky assets to hold, given knowledge of each asset's risk and return characteristics (risk in this case being defined as the volatility, or standard deviation, of returns) and the correlations between the different assets. The calculations will confirm that the less well correlated the components of your portfolio are, the better diversified you are.
That is fine as far as it goes, but - apart from requiring some fancy maths - the academic approach suffers from the disadvantage that it is wholly reliant on historic data. In the wrong hands, this can produce some bizarre results, as for example a few years ago when one of the City's grandest investment banks argued that investors should have 80 per cent in equities and 0 per cent in gilts - at the very point when the equity market was about to crater and gilts continued to produce their best returns for decades! Garbage in, garbage out, in other words.
Another danger is that even an optimised portfolio can lead you into difficulties, because short-term cash flows can force you into changing your asset mix even though it may be the optimal one for the longer term. You only have to look at how three years of a bear market turned many life companies into forced sellers of equities to see how this principle - which is a variant of the better-known syndrome known as gambler's ruin - is no idle danger.
Common sense can probably do at least as good a job. The truth, as far as I can see, is that investment is not a precise science, but a classic example of a business where it is better to be roughly right than precisely wrong. The common sense approach must be to take historic data as a starting point but then add some simple overriding adjustments on the simple contrarian principle that you want to reduce somewhat your exposure to assets that are overvalued and increase your exposure to undervalued ones.
The psychological drawback of this approach, as with all diversification, is that it means you are guaranteed not to do as well as you might have done if you had happened to have 100 per cent exposure to the asset class that in practice turns out to do best. You will in other words miss the very top of every bull market but do better when things are going badly. You cannot have it both ways, unfortunately.
So how then to assess the proportions of different assets to hold? One simple starting point is to look at how different combinations of assets would have worked in the past. I did this exercise some while ago with the data on UK equities, gilts and cash from 1899-2000. (Since then some of the data for the first half of the 20th century has been revised, and we have had a new bear market, but the general principles remain broadly the same). The table below shows the results of this exercise for various mixes of equities and gilts and equities and cash.
You can see at once how mixing either set of assets succeeds in bringing down both the volatility and the returns of each portfolio. Note how introducing gilts into the portfolio does virtually nothing to reduce the number of down years you would have experienced as a 20th-century investor, whereas introducing cash does have that effect. It also reduces the maximum loss in any one year. The band of potential returns is somewhat wider with gilts in the portfolio than it is with cash.
It is also of course possible to mix all three assets together and produce a new set of results. In recent years we now have the option of including other assets, such as property (for which we have good data going back about 35 years), index-linked gilts, corporate bonds and overseas equities. Putting all this information together in a usable format is not easy (and beyond the space of a newspaper column), but it is easy enough to study their various returns over time and see which ones tend to move together and which ones do not.
On top of this, finally, you have to introduce your judgements about the relative valuations of each class of asset. The simplest way to do this with equities and property is to compare them to their long-term averages and also look at how their yields (dividends or rental value) compare to alternatives.
With gilts and other fixed-interest securities, it is usually enough to take the current yield for say a 10-year-gilt and assume that this will be its total return over the next ten years (the correlation is very strong). Then look at the current and expected rate of inflation: if gilts are offering a real yield (after inflation) of 3 per cent per annum on these two measures, then they will normally be good value. Otherwise be wary.
Mark Dampier: 'We're on our own in retirement. They've pulled pensions to pieces'
Questions of Cash: I don't use Amazon Prime, but my credit card bill says I do
Donald MacInnes: 'I have to have £500 a month spare from now until at least 2035'
Crippling PFI deals leave Britain £222bn in debt
Pension freedoms: How to deal with cold calls from scammers
- 1 BBC election debate: The one photo that summed up the whole 90-minute leaders debate
- 2 18th century sex toy found in 'toilet of sword fighting school' in Poland
- 3 US? China? India? The 10 biggest economies in 2030 will be...
- 4 'I wish my teacher knew...': Young students share their 'heartbreaking' worries in notes
- 5 Rebecca Francis accuses Ricky Gervais of using 'influence' to target female hunters after receiving barrage of death threats
The only black face in the Ukip manifesto is on the page about overseas aid
If I’m being racially abused I don’t need a stranger with a saviour complex to rescue me
Ukip is the only main political party to not address LGBT rights in its manifesto
Food banks: One million Britons will soon be using them, according to Trussell Trust
BBC election debate: The one photo that summed up the whole 90-minute leaders debate
Religion isn't growing, it is becoming vigorous in its demise, says philosopher AC Grayling
iJobs Money & Business
£20000 - £25000 per annum + OTE £45,000: SThree: SThree Group have been well e...
£50000 - £667000 per annum + excellent benefits : Ashdown Group: IT Manager / ...
£13000 - £20000 per annum: Recruitment Genius: Scotland's leading life insuran...
£40000 - £45000 per annum + benefits : Ashdown Group: Training Programme Manag...
Day In a Page
With space for an equestrian business, a greenhouse for growing your own veg, a wine store and a gym; this five-bedroom home has all the ingredients for a country retreat.
This four-bedroom home has exposed brick chimneys and a vaulted ceiling in a breakfast room that's ideal for summer entertaining - the doors open to the patio and garden.
The decked roof terrace of this two-bedroom flat is perfect for summer drinks while large windows and ample storage space make for a light and spacious interior.
Surrounded by approximately 15 acres of grounds, this six-bedroom grade II-listed home has been extensively refurbished yet retains many period features.
This four-bedroom home comes with a two-bedroom cottage and commercial office, with planning to extend, in a stunning courtyard setting.
In a pretty Norfolk village, this four-bedroom family home is surrounded by landscaped gardens, with even a self-contained annex for guests.
A few miles from the seaside at Perranporth, this four-bedroom farmhouse sits amongst nine acres of idyllic grounds - including a lake and two barns used as holiday lets.
This five-bedroom home is arranged over three floors of a converted Victorian hospital, offering spectacular views of the Pentland Hills - only three miles from the city centre.
This four-bedroom detached home comes with grounds that span to approximately 2.5 acres, as well as two large patio areas and a double garage.
This four-bedroom cottage is a Grade II-listed town house, well-located for the thriving market town of Nailsworth.
A four-bedroom apartment on the ground floor of a stunning period property in North Yorkshire, with two kitchens and a large south-west facing garden.
This high-spec two-bedroom home is part of a smart collection of new flats at Beaufort Park and has a large decked balcony that's perfect for summer drinks.
Capitalise on the fabulous views of Trevone Bay by taking two homes and creating one spacious boutique B&B. Just a cliff-top walk from Padstow.
Overlooking a golf course, this six-bedroom Edwardian detached home spans four storeys and retains many period features including the original, operational servants' bells...
On the edge of the city, this six-bedroom home comes with an outdoor swimming pool and a large garage block that has annexe potential.
In a Grade II-listed manor just outside of Bath, this three-bedroom home is arranged on two floors with a skylight in a vaulted roof line.
Open the living room's bi-fold wooden doors to reveal a retro-style kitchen, and a conservatory leading to a paved garden at this three-bedroom home.
A Grade II-listed, four-bedroom home, in a charming Somerset village, with a two-storey studio that could be converted into a holiday cottage
A modern four-bedroom Victorian home, within walking distance to the high street
A luxury apartment in the Gothic mansion of Wyfold Court in Kingwood, offers six bedrooms spread over three floors and a turret
This school conversion, near Stockwell Tube, oozes New York loft style. The one-bedroom flat features double height ceilings and exposed brick work
This six-bedroom Georgian home is on three floors with open fireplaces, a two-oven Aga, an annexe, and cottage gardens with outbuildings and a car barn
High Crest House covers an impressive 9384sq ft, with almost three acres of grounds including a tennis court and summer house enclosed by electric gates
A six-bedroom farmhouse with separate accommodation in converted stables. Situated in the village of Church Aston, within walking distance to the market town
A two-bedroom flat with under-heated walnut floors and bespoke built-in storage. The Tube and Clapham Common are a short stroll away
A refurbished seven-bedroom townhouse with staff quarters, cinema room, superb gym, steam room and plunge pool
A minimnalist four-bedroom home designed to the highest spec, featuring glass walls and a kitchen space lit by a glass roof
Hibernate during winter and make your living during the summer at this busy guesthouse with panoramic sea views, in the village of Lynton
A four-bedroom penthouse next to the Tate with direct views of St Paul's from two floors of luxurious living space
A four-bedroom detached home surrounded by spacious gardens and woodland, close to New Pudsey
An 18th-century, three-bedroom home near Langstone Harbour built from ships beams with vaulted ceilings and wood burning stoves
A five-bedroom semi-detached home with a mix of period and modern features in a popular and convenient location
This five-bedroom red-brick beauty overlooks the village green and sits in just under two acres of land
A three-bedroom villa with self-contained flat, minutes from Lake Windermere
A five-bedroom Victorian home with four receptions, superb gardens and paddock in Pembury
An eight-bedroom house on the south side of the The Green with cinema, wine cellars and summer house
This 17th century beauty is full of rustic cosiness, while the detached home office means you can also run a business
Four exclusive apartments in a Grade II-listed former medical school with 2,275 sq ft of living space and 18ft ceilings
A five-bedroom terraced house on the popular Peterborough Estate, ideally located for both Eel Brook Common and South Park
A state-of-the-art farm-building conversion on the former Cliveden Estate, with 11,420sq ft of internal space, cinema and wine cellar
Windsor Castle overlooks this three-bedroom Victorian cottage located on one of Windsor's smartest roads
A boutique mews house, set around a central courtyard, with three bedrooms and a private roof terrace
A four-bedroom farm-conversion with three bathrooms and two reception rooms
A two-bedroom detached house with ensuite bathrooms and a sun-drenched decked terrace, £750,000
A modern and spacious two-bedroom, penthouse flat with two bathrooms in a prestigious development
A beautifully renovated five-bedroom terrace with three reception rooms and a courtyard garden, £700,000
A four-bedroom period house which has been extended to provide almost 2,500sq ft of living space, £675,000
A pretty three-bedroom Georgian home with a 22ft drawing room and a master suite with a balcony, £525,000